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Make or Buy Decision and Transfer Pricing

A company makes remotely controllable model airplane. The company has two
divisions, D1 and D2. Division D1 makes airplane model kit. Division D2 assembles and
configures model airplane. A new airplane model has been developed of which the company
will sell for $160 each. Division D2 of the company has planned to produce 1,000 units of
fully assembled model airplane using its idle capacity. The division can either purchase the
model kit from Division D1 or purchase it from an outside supplier for $130. The company
has a policy that internal transfers are priced at their fully allocated costs.
Assume that the variable cost and allocated fixed cost for each airplane model kit at Division
D1 are $75 and $25, respectively.
Also assume that the assembling and administrative variable costs for each model airplane at
Division D2 are $50 and $15, respectively.

(1) Assume that Division D1 has idle capacity of producing the 1,000 sets of airplane model
kit for Division 2. Should the Division D2 purchase the airplane model kit from Division
D1? Would the company as a whole benefit if Division D2 decides to purchase from
Division D1?
(2) Assume that Division D1 doesn't have any idle capacity and the required airplane model
kit can be sold to outside customers for $115. Would the company as a whole benefit if
the Division D2 purchases the model kit from Division D1?
(3) Assume that the allocated fixed cost for each model airplane at Division D2 is $38. The
1,000 model planes are produced using the model kit from Division D1 for the company's
EU sales division, which sells the model airplane for $225 each. Suppose the EU and US
governments allow either the variable or fully allocated cost to be used as a transfer price.
The US income tax is 35%, the EU income tax is 60%, and the import duty to EU is 15%.
Which price should the company use to minimize the total of income taxes and import
duties? Compute the saving from your choice of transfer price versus the other.
(4) If EU has passed a new law decreasing the income tax rate to 50% and increasing the
import duty to 20%, what would be the choice of transfer price in (3)?

Solution Summary

This solution compares the income of a company and how purchases within or outside affects the value with step-by-step calculations and workings in an excel file, it also suggests which transfer pricing method to use.

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