International Transfer Pricing Considerations

Prof. S. Sridharan

American Computers, Inc.

American Computers has three divisions. Its Chinese Division produces memory chips,
keyboard packages and other components. These are transferred to the South Korean
Division of the company, where these parts, together with other parts and components,
are assembled into a fully finished final product, computers. These computers are then
transferred to the US Division, in which final market they are sold.

The company is considering three different transfer pricing options, market price, 200%
of full costs and 300% of variable costs. Assume that whatever method of transfer price
the company chooses, it is required to use the same method uniformly across all three
divisions and that the tax authorities in each one of these three tax jurisdictions would
agree to that method. Then, consider the facts given below in answering the questions
that follow:

Exchange rates to be used:

1 U.S. $ = 8 yuan
1 U.S $ = 1,200 won

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China

Price per memory/keyboard package 3,600 yuan

Variable costs 1,000 yuan
Fixed costs 1,800 yuan
Income tax
rate 40%

South Korea Division

Price per computer 1,560,000 won

Variable costs 360,000 won
Fixed costs 480,000 won
Income tax
rate 20%

U.S.A. Division

Price per computer $3,200

Variable costs $100
Fixed costs $200
Income tax
rate 30%

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1. What transfer price maximizes world-wide income for the firm as a
whole? (Assume that tax authorities in each country would agree with
whatever TP the firm chooses.)

2. What transfer price would each division prefer?

3. What are the advantages of using cost-based transfer prices for the
Chinese and South Korean divisions?

4. What are the drawbacks of using cost-based transfer prices for the
Chinese and South Korean divisions?

5. Suppose the transfer price for each division is set at 300% of variable
costs, but each division enjoys full autonomy, i.e., each division decides
on how much to sell to a downstream division or to buy from an
upstream division. Assuming that the market for intermediate
products is unlimited:
o How many units of memory devices can the South Korean
division obtain from the Chinese division?

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6. Suppose the market price for the product of the Chinese division
increases to $700. Assume that the capacity of the Chinese division is
1,000 units and the market for its output is limited 800 units. The firm
uses market price as the transfer price and all divisions enjoy complete
autonomy.

o How many units will be transferred from China to South

Korea in equilibrium, if the South Korean divisions fixed
costs consist entirely of depreciation on its equipment?

o How many units will be transferred from China to South

Korea in equilibrium, if the South Korean divisions fixed
costs consist entirely of cash costs that can be avoided in the
event of a closure of this division?

7. Consider the same facts as in (6) above. What is the optimal decision
from the perspective of the firm as a whole?