Chapter 13, Problem 48P

Alpha Communications, Inc., which produces telecommunications equipment in the United States, has a very strong local market for its circuit board. The variable production cost is $130, and the company can sell its entire supply domestically for $170. The U.S. lax rate is 40 percent.

Alternatively, Alpha can ship the circuit board to its division in Germany, to be used in a product that the German division will distribute throughout Europe. Information about the German product and the division’s operating environment follows.

Selling price of final product: $360

Shipping fees to import circuit board: $20

Labor, overhead, and additional material costs of final product: $115

Import duties levied on circuit board (to be paid by the German division): 10% of transfer price German tax rate: 60%

Assume that U.S. and German tax authorities allow a transfer price for the circuit board set at either U.S. variable manufacturing cost or the U.S. market price. Alpha’s management is in the process of exploring which transfer price is better for the firm as a whole.

Required:

1. 1. Compute overall company profitability per unit if all units are transferred and U.S. variable manufacturing cost is used as the transfer price. Show separate calculations for the U.S. operation and the German division.
2. 2. Repeat requirement (1), assuming the use of the U.S. market price as the transfer price. Which of the two transfer prices is better for the firm?
3. 3. Assume that the German division can obtain the circuit board in Germany for $155.
   1. a.      If you were the head of the German division, would you rather do business with your U.S. division or buy the circuit board locally? Why?
   2. b.      Rather than proceed with the transfer, is it in the best interest of Alpha to sell its goods domestically and allow the German division to acquire the circuit board in Germany? Why? Show computations to support your answer.
4. 4. Generally speaking, when tax rates differ between countries, what strategy should a company use in setting its transfer prices?
5. 5. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (1) and (2) above. Show how the solution will change if the following information changes: the U.S. tax rate is 35 percent, the German tax rate is 55 percent, and the import duties are 8 percent of the transfer price.

To determine

Calculate the overall profitability per unit of company A and show separate calculation for U.S. operation and German operation.

Explanation of Solution

Return on investment (ROI): Return on investment evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of a units or divisions or a companies.

Calculate the overall profitability per unit of company A and show separate calculation for U.S. operation and German operation as follows:

Profitability per unit of U. S. Operation:

Particulars	$ per unit
Sales revenue	$130.00
Less: Variable cost	$130.00
Contribution margin	$0

Table (1)

Profitability per unit of German Operation:

Particulars	$ per unit	$ per unit
Sales revenue		$360.00
Less:     Transfer price	$130.00
Shipping fees	$20.00
Additional processing costs	$115.00
Import duties $\left(\$130\times 10\%\right)$	$13.00	$278.00
Income before tax		$82.00
Less: Income tax expense $\left(\$82\times 60\%\right)$		$49.20
Income after tax		$32.80

Table (2)

Overall profitability per unit of company A:

$\begin{array}{c}\begin{array}{l}\text{Overall profitability }\\ \text{per unit of Company A}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Profitability per unit of U}\text{.S}\text{. Operation+}\\ \text{Profitability per unit of German Operation}\end{array}\right)\\ =\$0+\$32.80\\ =\$32.80\end{array}$

To determine

Calculate the overall profitability per unit of company A and show separate calculation for U.S. operation and German operation if company uses the U.S market price as the transfer price. Indicate the transfer price which is best for the firm.

Explanation of Solution

Calculate the overall profitability per unit of company A and show separate calculation for U.S. operation and German operation if company uses the U.S market price as the transfer price as follows:

Profitability per unit of U. S. Operation:

Particulars	$ per unit
Sales revenue	$170.00
Less: Variable cost	$130.00
Income before tax	$40.00
Less: Income tax expense $\left(\$40\times 40\%\right)$	$16.00
Income after tax	$24.00

Table (3)

Profitability per unit of German Operation:

Particulars	$ per unit	$ per unit
Sales revenue		$360.00
Less:     Transfer price	$170.00
Shipping fees	$20.00
Additional processing costs	$115.00
Import duties $\left(\$130\times 10\%\right)$	$13.00	$322.00
Income before tax		$38.00
Less: Income tax expense $\left(\$38\times 60\%\right)$		$22.80
Income after tax		$15.20

Table (4)

Overall profitability per unit of company A:

$\begin{array}{c}\begin{array}{l}\text{Overall profitability }\\ \text{per unit of Company A}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Profitability per unit of U}\text{.S}\text{. Operation+}\\ \text{Profitability per unit of German Operation}\end{array}\right)\\ =\$24.00+\$15.20\\ =\$39.20\end{array}$

In this case, U.S. market price is better for the firm because it provides higher profitability ($39.20) than the U.S. variable manufacturing cost ($32.80).

To determine

Explain whether the company can do business with U.S. division or buy the circuit board locally if the German division can obtain the circuit board for $155.

Explanation of Solution

When the circuit board can be obtained locally for $155, it is difficult to get excited to do business, because the cost of local circuit board ($155) is less than the cost of German division circuit board $\left(\$130+\$20+\$13=\$163\right)$. At the same time, it is an advantages for the company to purchase in local (Germany) because both shipping fees and import duty can be avoidable. Hence, the German division is better option for purchasing the circuit board in local (German).

To determine

Explain whether company A can make circuit board or not if company does not have any transfer price and show necessary calculations.

Explanation of Solution

Explain whether company A can make circuit board or not if company does not have any transfer price and show necessary calculations as follows:

Profitability per unit of U. S. Operation:

Particulars	$ per unit
Sales revenue	$170.00
Less: Variable cost	$130.00
Income before tax	$40.00
Less: Income tax expense $\left(\$40\times 40\%\right)$	$16.00
Income after tax	$24.00

Table (5)

Profitability per unit of German Operation:

Particulars	$ per unit	$ per unit
Sales revenue		$360.00
Less:     Transfer price	$155.00
Additional processing costs	$115.00	$270.00
Income before tax		$90.00
Less: Income tax expense $\left(\$90\times 60\%\right)$		$54.00
Income after tax		$36.00

Table (6)

Overall profitability per unit of company A:

$\begin{array}{c}\begin{array}{l}\text{Overall profitability }\\ \text{per unit of Company A}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Profitability per unit of U}\text{.S}\text{. Operation+}\\ \text{Profitability per unit of German Operation}\end{array}\right)\\ =\$24.00+\$36.00\\ =\$60.00\end{array}$

Yes, Company A will make circuit board and sold in U.S. when the company does not have any transfer price, because the overall profitability without transfer price ($60 per unit) is more than the overall profitability with transfer price ($39.20 per unit).

To determine

Explain the strategy that should a company use in setting the transfer prices when the tax rates differ between countries.

Explanation of Solution

In this case, the company should try to generate less income in high tax rate countries and high income in low tax rate countries when the tax rates differ. It is a best strategy to avoid more taxes in setting the transfer prices.

To determine

Prepare a spreadsheet and solve the requirement (1) and (2) if the U.S. tax rate is 35% and German tax rate is 55%.

Explanation of Solution

Prepare a spreadsheet and solve the requirement (1) and (2) if the U.S. tax rate is 35% and German tax rate is 55% as follows:

Figure (1)

Excel workings:

Figure (2)