AQ-9

Part A

Explain the significance of excess capacity in the transferring division when transfer prices are set using the general transfer-pricing rule.

Part B (Mornay Company)

The Mornay Company manufactures telecommunications equipment at its plant in Toledo, Ohio.The company has marketing divisions throughout the world. A Mornay marketing division in Vienna, Austria, imports 1,000 units of Product 4A36 from the United States. The following information is available:

U.S. income tax rate on the U.S. division's operating income	40%
Austrian income tax rate on the Austrian division's operating income	44%
Austrian import duty	10%
Variable manufacturing cost per unit of Product 4A36	$350
Full manufacturing cost per unit of Product 4A36	$500
Selling price (net of marketing and distribution costs) in Austria	$750

Suppose the U.S. and Austrian tax authorities only allow transfer prices that are between full manufacturing cost per unit of $500 and a market price of $650, based on comparable imports into Austria. The Austrian import duty is charged on the price at which the product is transferred into Austria. Any import duty paid to the Austrian authorities is a deductible expense for calculating Austrian income taxes due.

Required:

1. Calculate the after-tax operating income earned by the U.S. and Austrian division from transferring 1,000 units of Product 4A36 (a) at full manufacturing cost per unit and (b) at market price of comparable imports. (Income taxes are not included in the computation of the cost-based transfer price.

2. Which transfer price should Mornay Company select to minimize the total of company import duties and income taxes? Remember that the transfer price must be between full manufacturing cost per unit of $500 and the market price of $650 of comparable imports into Austria. Explain your reasoning.

AQ-9 (Mornay Company) (continued)

Suppose that the U.S. division could sell as many units of Product 4A36 as it makes at $600 per unit in the U.S. market, net of all marketing and distribution costs.

3. From the viewpoint of the Mornay company as a whole, would after-tax operating income be maximized if it sold the 1,000 units of Product 4A36 in the United States or in Austria? Show your computations.

4. Suppose division managers act autonomously to maximize their divisions after-tax operating income. Will the transfer price calculated in requirement 2 result in the U.S. division manager taking the actions determined to be optimal in requirement 3? Explain.

5. What is the minimum transfer price that the U.S. division manager would agree to? Does this transfer price result in the Mornay Company as a whole paying more import duty and taxes than the answer to requirement 2? If so, by how much?