Industrial Diamonds, Inc., based in Montreal, Quebec, has two divisions:
◆ South African Mining Division, which mines a rich diamond vein in South Africa.
◆ Canadian Processing Division, which polishes raw diamonds for use in industrial cutting tools.
The Processing Division’s yield is 50%: It takes two pounds of raw diamonds to produce one pound of top-quality polished industrial diamonds. Although all of the Mining Division’s output of 4,000 pounds of raw diamonds is sent for processing in Canada, there is also an active market for raw diamonds in South Africa. The foreign exchange rate is 7 ZAR (South African Rand) = $1 CAD. The following information is known about the two divisions:
1. Compute the annual pre-tax operating income, in Canadian dollars, of each division under the following transfer-pricing methods: (a) 200% of full cost and (b) market price.
2. Compute the after-tax operating income, in Canadian dollars, for each division under the transfer-pricing methods in requirement 1. (Income taxes are not included in the computation of cost-based transfer price, and Industrial Diamonds does not pay Canadian income tax on income already taxed in South Africa.)
3. If the two division managers are compensated based on after-tax division operating income, which transfer-pricing method will each prefer? Which transfer-pricing method will maximize the total after-tax operating income of Industrial Diamonds?
4. In addition to tax minimization, what other factors might Industrial Diamonds consider in choosing a transfer-pricing method?