Question

ABC Cycle makes bicycles for people of all ages. The frames division makes and paints the frames and supplies them to the assembly division where the bicycles are assembled. ABC Cycle is a successful and profitable corporation that attributes much of its success to its decentralized operating style. Each division manager is compensated on the basis of division operating income. The assembly division currently acquires all its frames from the frames division. The assembly division manager could purchase similar frames in the market for $480. The frames division is currently operating at 80% of its capacity of 4,000 frames (units) and has the following details: Direct materials ($150 per unit x 320 units) Direct manufacturing labour ($60 per unit x 3,200 units) Variable manufacturing overhead costs ($30 per unit x 3,200 units) Fixed manufacturing overhead costs $480,000 192,000 96,000 $624,000 All the frames division’s 3,200 units are currently transferred to the assembly division. No frames are sold in the outside market. The frames division has just received an order for 2,000 units at $450 per frame that would utilize half the capacity of the plant. The order has to be either taken in full or rejected totally. The order is for a slightly different frame than what the frames division currently makes but takes the same amount of manufacturing time. To produce the new frame would require direct materials per unit of $100, direct manufacturing labour per unit of $48, and variable manufacturing overhead costs per unit of $30.

consider the effect of income taxes.

a. Suppose the assembly division is located in a country that imposes a 10% tax on income earned within its boundaries, while the frames division is located in a country that imposes no tax on income earned within its boundaries. What transfer price would be chosen by Speed Racer to minimize tax payments for the corporation as a whole? Assume that only transfer prices that are greater than or equal to full manufacturing costs and less than or equal to the market price of “substantially similar” frames are acceptable to the taxing authorities.

b. Suppose that ABC cycle announces the transfer price computed in question 4a to price all transfers between the frames and assembly divisions. Each division manager then acts autonomously to maximize division operating income. Will division managers acting in a decentralized manner achieve the actions determined to be optimal in question 1? 5.Consider your responses to questions 1 to 4 and assume the frames division will continue to have opportunities for outside business as described in question 1. What transfer-pricing policy would you recommend Speed Racer use and why? Would you continue to evaluate division performance on the basis of division operating incomes?

Answer 1

Refer to the below images for the above mentioned questions in a detailed way of solution with explanation.

Reqsirement a) To minimize taxes, ABC should transfer the frames at the marteet price of $480. The frames division would pay no takes on any income that it would report. By setting the transfer price as high as possible, the Assembly division would minimize the income it would report and hence the taxes it would pay. yes, as in part 3b, the transfer price of $480 is also within the range identified in reajoisement a and So will achieve the outcome deseried in reajuirement ! (seit 2000 frames under the outside offer & transfer 2000 frames to the Assembly Division). Realtirement 3: Recommend that ABC use a transfer price of $480 for transferring frames from the frames division to the Assembly Divisione This transfer price minimizes day payments for ABC as a whole and also achieves goal congruence. That is, at a transfer price of $480 for all frames transferred from the frames Division to the Assembly Division, both Divisions will be content with the following arrangement: a) The frames Division will make 2000 frames for outside customers and 2000 frames for the Assembly Division. b) The assembly division will tance 2000 trames from the frames Division and the remaining frames from the outside market.

of course the Assembly Division manager would like to negotiate a price lower than $480 (but greater than $240) for the 2000 frames from the frames Division, but this would increase ABC'S tax payments. At a transfer price of $480, it would still be alright to evaluate each division's performance on the basis of division operating income because the transfer price of $480 approximates the marreet prices for the frames transferred from the frames Division to the Assembly Division - Market - based transfer prices give top management a reasonably good picture of the contributions of the individual divisions to overall company wide profitability. - - -