Kay Enterprises is a small family owned and managed business
Kay Enterprises is a small, family- owned and managed business. It has a patented production process for manufacturing a digital switch used in large telephone switches. It manufactures two models in its plant in Atlanta, Georgia. The U. S. model is sold to U. S.- based telephone companies and the European switch is transferred to Kay’s wholly owned subsidiary in Ireland, where it is sold to European telephone companies. U. S. switches are sold only in the United States and European switches can be sold only in Europe. One brother, Lloyd Kay, manages the U. S. company and his brother, Colin Kay, manages the Irish firm. The two switches share the same proprietary production process but have different design specifications to match the different telephone systems.
All switches manufactured are sold; Kay does not have any work- in- process or finished goods inventories. Because of the patented nature of the production process, Kay faces very little competition for its switches either in the United States or Europe. This allows the firm to set a relatively high price above its costs.
The following table summarizes the annual number of U. S. and European switches produced and the costs of manufacturing each switch. All manufacturing overhead of $ 24 million is a fixed cost that does not vary with the number of switches produced. Overhead is allocated to units produced based on direct labor dollars.

Because Kay operates in two countries, it must calculate and report income by country. Assume that the United States has a 35 percent income tax rate on U. S. derived income. Profits of firms in Ireland are taxed at 10 percent to encourage foreign investment. In recent years, the U. S. and Irish tax authorities have scrutinized Kay’s full- cost transfer pricing policy. The tax authorities become suspicious if a different transfer price is used for taxes than for other purposes. Kay transfers the European switches at full accounting cost ( direct labor, direct material, and allocated overhead).

a. Prepare separate income statements for each country for Kay Enterprises for the current operating year using direct labor dollars to allocate manufacturing overhead to the switches.
b. Kay is considering switching to activity- based costing for allocating overhead to the two models of switches. Upon analysis of the production process it is determined that most of the $ 24 million of manufacturing overhead varies with the number of batches produced. The equipment is set up between batches; raw materials are ordered and inspected on a batch basis. The quality control department checks five units per batch. Packing and shipping costs vary with the number of batches. After conducting this analysis, Kay decides to switch to ABC for allocating manufacturing costs. European switches are produced in batch sizes of 20,000 and U. S. switches are produced in batch sizes of 30,000. Prepare separate income statements for each country for Kay Enterprises for the current operating year using ABC to allocate manufacturing overhead to the switches.
c. Which set of income statements (those in part [ a ] or [ b ]) should Kay Enterprisesuse?
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