PROBLEM

1. Harrington, Inc., imports merchandise that it resells in the United States. The merchandise is stored
in a company warehouse located in a foreign trade zone. The average shipment of merchandise costs
$800,000, and on average, the inventory is stored for four months before it is moved from the
warehouse in the foreign trade zone. Inventory shrinkage at the warehouse due to breakage is about
4 percent of the total. The average tariff rate on the imports is 15 percent. The company's carrying
cost is 12 percent.

Required:

a. Determine total tariff and tariff-related costs per shipment, given that the warehouse is
located in a foreign trade zone.
b. Determine total tariff and tariff-related costs per shipment if the warehouse were not
located in a foreign trade zone.
c. Determine the annual cost savings due to the warehouse's location in a foreign trade zone.

ANS:
a. Tariff paid per shipment ($800,000 96% 15%) $115,200

b. Tariff paid at purchase ($800,000 15%) $120,000

Carrying cost of tariff ($800,000 15% 12% 4/12) 4,800
Total tariff and tariff-related cost per shipment $124,800

c. Cost savings per shipment = $124,800 - $115,200 = $9,600

$9,600 per shipment 3 shipments per year = $28,800

2. Trenton, Inc., imports merchandise from Hong Kong for distribution in the United States. On March
1 the company purchased merchandise costing 700,000 Hong Kong dollars. Payment is due on June
1. The exchange rates for $1 U.S. were as follows:

Spot rate, March 1 7.00 Hong Kong dollars

Spot rate, June 1 8.00 Hong Kong dollars

Required:

a. How much would Trenton have to pay for the purchase in U.S. dollars if it paid on March 1?
b. How much would Trenton have to pay for the purchase in U.S. dollars if it paid on June 1?

ANS:
a. 700,000 Hong Kong dollars/7 = $100,000
b. 700,000 Hong Kong dollars/8 = $87,500

3. Greatlakes, Inc., imports merchandise from Taiwan for distribution in the United States. On
February 1 the company purchased merchandise costing 500,000 Taiwan dollars. Payment is due on
May 1. The exchange rates for $1 U.S. were as follows:

Spot rate, February 1 27.00 Taiwan dollars

Spot rate, May 1 25.00 Taiwan dollars
 Required:

a. How much would Greatlakes have to pay for the purchase in U.S. dollars if it paid on February 1?

b. How much exchange gain or loss (if any) will Greatlakes recognize if it pays for the purchase in
U.S. dollars on May 1?

ANS:
a. 500,000 Taiwan dollars/27 = $18,519

b. Liability, February 1 (500,000 T$/27) $18,519

Amount paid, May 1 (500,000 T$/25) 20,000
Exchange loss $ 1,481

4. On July 1, Ponderosa, Inc., received an order from an Italian customer for 700,000 lira to be paid on
September 1. The exchange rates for $1 U.S. were as follows:

Spot rate, July 1 1,500 lira

Forward rate, September 1 1,700 lira
Spot rate, September 1 2,000 lira

Required:

a. If Ponderosa receives payment from the Italian customer using the spot rate at the time of
payment, what would be Ponderosa's exchange gain or loss?
b. If Ponderosa's policy is to hedge foreign currency transactions, what is Ponderosa's
exchange gain or loss?

ANS:
a. Receivable in dollars, July 1 (700,000/1,500) $467
Received in dollars, September 1 (700,000/2,000) 350
Exchange loss $117
b. Receivable in dollars, July 1 (700,000/1,500) $467
Forward contract (700,000/1,700) 412
Exchange loss $ 55

5. Wheatfield, Inc., imports merchandise from Germany for distribution in the United States. On May
1, the company purchased merchandise costing 120,000 Deutsche marks (DM). Payment is due in
Deutsche marks on July 1. The exchange rates for $1 U.S. were as follows:

Spot rate, May 1 1.60 DM

Spot rate, July 1 1.50 DM
 Required:

Determine the exchange gain or loss on the transaction.

ANS:
Liability, May 1 (120,000 DM/1.60) $75,000
Amount paid, July 1 (120,000 DM/1.50) 80,000
Exchange loss $ 5,000

6. On February 1, Bakersfield, Inc., received an order from a Swiss customer for 15,000 Swiss francs
to be paid on April 1. The exchange rates for $1 U.S. were as follows:

Spot rate, February 1 1.20 Swiss francs

Spot rate, April 1 1.50 Swiss francs

Required:

Determine the exchange gain or loss on the transaction.

ANS:
Receivable, February 1 (15,000 SF/1.20) $12,500
Amount received, April 1 (15,000 SF/1.50) 10,000
Exchange loss $ 2,500

7. On November 1, Stoker, Inc., purchased merchandise from a Japanese supplier costing 480,000 yen
to be paid on December 15. The rates for $1 U.S. were as follows:

Spot rate, November 1 128 yen

Forward rate, December 15 125 yen
Spot rate, December 15 120 yen

Required:

a. Determine Stoker's exchange gain or loss using the spot rate at December 15.
b. Determine Stoker's exchange gain or loss if Stoker has a policy of hedging foreign currency
transactions.

ANS:
a. Payable in dollars, November 1 (480,000/128) $3,750
Paid in dollars, December 15 (480,000/120) 4,000
Exchange loss $ 250

b. Payable in dollars, November 1 (480,000/128) $3,750

Forward contract (480,000/125) 3,840
Exchange loss $ 90
8. Minaret, Inc., has two manufacturing plants. One is located in Hong Kong and the other in El Paso,
Texas. The El Paso plant is located in a foreign trade zone. The Hong Kong plant manufactures a
component used in the manufacture of the El Paso plant's main product. Recently, El Paso ordered
parts with a cost-plus transfer price of $20,000 (U.S. dollars). Typically, 3 percent of the parts
shipped to El Paso by the Hong Kong plant are defective. The U.S. tariff on the component parts is
25 percent. The part typically remains in the El Paso plant for approximately three months before it
is shipped out as part of El Paso's finished product. The company's carrying cost is 14 percent.
(Round to the nearest dollar.)

Required:

a. Determine the total cost of the imported parts that the El Paso plant will incur, given its
location in a foreign trade zone.

b. Determine the total cost that would have been incurred if the warehouse had not been
located in a foreign trade zone.

c. Comment on Minaret's transfer price policy.

ANS:
a. Component part cost $20,000
Tariff paid per shipment ($20,000 97% 25%) 4,850
Total component cost $24,850

b. Component part cost $20,000

Tariff paid at purchase ($20,000 25%) 5,000
Carrying cost of tariff ($20,000 25% 14% 3/12) 175
Total component cost $25,175

c. The cost-plus method of determining a transfer price is acceptable to the IRS but is less
desirable than the comparable uncontrolled price method or the resale price method.

9. Ginger TeleManufacturing Company has three subsidiaries that are located in Austria, the United
States, and Brazil. The Austrian plant manufactures a finished product and exports it to the U.S. and
Brazilian subsidiaries. The Austrian income tax rate is 44 percent, the U.S. income tax rate is 35
percent, and the Brazilian income tax rate is 30 percent. Import duty for the United States is 10
percent and for Brazil is 18 percent. The component's costs are as follows:

Variable costs $30

Fixed costs 14
Shipping cost 5
Commission 4
 The component sells for $70 in the United States and $65 in Brazil. The Austrian company has
excess capacity to produce 10,000 units annually. Shipping cost is paid by the buying subsidiary.
The commission is not incurred when sold to another subsidiary.
Required:

a. Assume the component is very popular and both the U.S. and Brazilian subsidiaries can
sell 10,000 units. How many units should be sold to the U.S. subsidiary and how many to
the Brazilian subsidiary? At what transfer price?

b. Assume that all the components would be sold to the U.S. subsidiary and that the market
price of the component in Austria is also $70. What transfer price would the IRS prefer?
ANS:
a. U.S. subsidiary: Transfer price ($44) should be cost, because the income tax rate is lower
in the United States than in Austria.

Austria U.S. Total

Sales 44.00 70.00
Costs (44.00) (44.00)
Shipping cost (5.00)
Tariff (10%) (4.40)
Profit before tax -0- 16.60
Income tax -0- 5.81
Profit after tax 10.79 107,900

Brazil subsidiary: Transfer price ($44) should be cost, because the income tax rate is lower
in Brazil than in Austria.

Austria Brazil Total

Sales 44.00 65.00
Costs (44.00) (44.00)
Shipping cost (5.00)
Tariff (18%) (7.92)
Profit before tax -0- 8.08
Income tax -0- 2.42
Profit after tax 5.66 56,600

The Austrian subsidiary should sell the 10,000 components to the U.S. subsidiary at a
transfer price of $44. The overall profits of the company would be higher.

b. The IRS would prefer the comparable uncontrolled price method that uses the market
price.

Market price 70
Shipping cost 5
Commission (4)
Transfer price 71