Question

The American Battery Company has two divisions, the Electrical Division and the Assembly Division. Both divisions have the full authority to make purchasing and selling decisions of their division output to both outsiders and the other division. (A highly decentralized structure) Each Division operates as a separate profit center and is being evaluated on the basis of the divisionʹs reported profit. The Electrical Division makes the battery cores (inside components) of the battery, and the Assembly Division places those cores in a decorative customized casing to sell to customers. The Electrical Division capacity is 350,000 cores which are sold to both outside parties and the Assembly Division. They can sell the core to outsiders for $150 per unit. The production costs per battery incurred by the Electrical Division are as follows:
Direct materials $ 40
Direct manufacturing labor 30
Variable factory overhead 12
Fixed factory overhead 40
Total $122
The Assembly Division can buy the cores from an outside source for $145. The division adds $25 of incremental costs, and then sells the assembled battery for $190.

QUESTION:

Assuming the Electrical Division has sufficient capacity to supply the Assembly Division. The Electrical Division is located in Mexico with a tax rate of 20%, and the Assembly Division is located in the US with a tax rate of 40%. US and Mexican tax authorities only allow for transfer prices to be set between the full cost of $122 and the selling price of $150. Only considering tax consequences, should the company set the transfer price at $122 or $150? Why?
A) $122, because at a transfer price of $122, the companyʹs total amount of tax paid per unit in both countries will be $17.20 less.
B) $150, because at a transfer price of $150, the companyʹs total amount of tax paid per unit in both countries will be $17.20 less.
C) $122, because at a transfer price of $122, the companyʹs total amount of tax paid per unit in both countries will be $5.60 less.
D) $150, because at a transfer price of $150, the companyʹs total amount of tax paid per unit in both countries will be $5.60 less.

Answer 1

Electric Divison

Direct Material	$40
Direct Labor	$30
Variable factory Overhead	$12
Fixed factory Overhead	$40
Total Cost	$122

Case a. if transfer price is $122 then electric divison will pay no taxes.

Case b. if transfer price is $150 then electric division will pay tax as under:

($150-$122)= $28*20%= $5.6

Assembley Divison

	If transfer prce is $122	if transfer price is $150
Electric divison component	$122	$150
Incremental cost	$25	$25
Total cost	$147	$175

Case a. Assembley divison will pay tax as under:

$190-$147 = $43*40% = 17.2$

Case b. Assembley divison will pay tax as under:

$190-$175 = $15*40% = $6

Total tax paid by company in case a = $0+$17.2 = $17.2

Total tax paid by company in case b = $5.6+$6 = $11.6

Case b is better option and transsfer price should be $150