Question

Padre Inc., a U.S. company, has two subsidiaries, Hijo and Amery. Hijo is located in Brazil and Amery in the U.S. The tax rate is 17% in Brazil and 21% in the U.S. The full cost per unit is $5 for Hijo. Amery sells the units in the U.S. at $15 per unit. Ignore any other costs. Option 1: Hijo transfers 100 units of coca to Amery at a negotiated transfer price of $10 per unit. Option 2: Padre intervenes to set the transfer price at $13 per unit. Which TP produces the higher net profit? Option 1 Hijo Amery Padre Sales COGS Gross profit Income tax effect After-tax profit Option 2 Hijo Amery Padre Sales COGS Gross profit Income tax effect After-tax profit Padre Inc., a U.S. company, has two subsidiaries, Hijo and Amery. Hijo is located in Brazil and Amery in the U.S. The tax rate is 17% in Brazil and 21% in the U.S. Amery sells the units in the U.S. at $15 per unit. Ignore any other costs. Assume, instead of full cost per unit is $5, Hijo's variable cost per unit is $5 and fixed cost per unit is $3. Amery's per unit fixed cost is $4. Do your calculation to show the new results for option 1 and option 2. Option 1: Hijo transfers 100 units of coca to Amery at a negotiated transfer price of $10 per unit. Option 2: Padre intervenes to set the transfer price at $13 per unit.

Answer 1

Scenario 1:

Option 1:

	Hijo	Armery	Padre
Sales	100*10= 1000	100*15=1500	1500
COGS	100*5= 500	100*10= 1000	500
Gross Profit	500	500	1000
Income Taxes	85	105	85+105 = 190
After Tax profit	415	395	810

Option 2:

	Hijo	Armery	Padre
Sales	100*13 = 1300	100*15 = 1500	1500
COGS	100*5 = 500	100*13 = 1300	500
Gross Profit	800	200	1000
Income Taxes	136	42	178
After Tax profit	664	158	822

Hence, option 2 generates Higher overall net profit to Padre.

Scenario 2:

Option 1:

	Hijo	Armery	Padre
Sales	1000	1500	1500
Variable Cost	100*5 =500	1000	500
Fixed Cost#	100*3 = 300	100*4 = 400	700
Gross Profit	200	100	300
Income Taxes	34	21	55
After Tax profit	166	79	245

^# assuming total fixed costs are absorbed in 100 units.

Option 2:

	Hijo	Armery	Padre
Sales	1300	1500	1500
Variable Cost	500	1300	500
Fixed Cost	300	400	700
Gross Profit	500	-200	300
Income Taxes*	85	0	85
After Tax profit	415	-200	215

*Problem is silent about Income tax on losses. Hence, it is assumed there are no carry forward of losses possible. Hence, Taxes on loss is ZERO.

Hence. Option 1 is better.

Please Comment is case of any query regarding the solution.