Week 8

Suggested Solutions to Class Questions

Problem 14-15 (30 minutes) 1. (1) Sales (2) Net operating income (3) Operating assets (4) Margin (2) (1) (5) Turnover (1) (3) (6) ROI (4) x (5)

Present New Line 10,000,000 2,000,000 800,000 160,000* 4,000,000 1,000,000 8% 8% 2.5 2 20% 16%

Total 12,000,000 960,000 5,000,000 8% 2.4 19.2% 2,000,000 1,200,000 800,000 640,000 160,000

* Sales Less variable expenses (60% x 2,000,000) Contribution margin Less fixed expenses Net operating income

2. Dell Havasi will be inclined to reject the new product line, since accepting it would reduce his divisions overall rate of return. 3. The new product line promises an ROI of 16%, whereas the companys overall ROI last year was only 15%. Thus, adding the new line would increase the companys overall ROI figure (assuming that a higher return than 16% cant be gained elsewhere on some other investment opportunity). 4. a. Operating assets Minimum return required Minimum net operating income Actual net operating income Minimum net operating income (above) Residual income Present 4,000,000 x 12% 480,000 800,000 480,000 320,000 New Line 1,000,000 x 12% 120,000 160,000 120,000 40,000 Total 5,000,000 x 12% 600,000 960,000 600,000 360,000

b. Under the residual income approach, Dell Havasi would be inclined to accept the new product line, since adding the line would increase the total amount of his divisions residual income, as shown above.

Exercise 15-6 (20 minutes) 1. The lowest acceptable transfer price from the perspective of the selling division is given by the following formula:

Transfer price

Variable cost Total contribution margin on lost sales Number of units transferred per unit .

There is no idle capacity, so each of the 40,000 units transferred from Division X to Division Y reduces sales to outsiders by one unit. The contribution margin per unit on outside sales is 20 (= 90 70).

Transfer price (70 3)

20 40,000 67 + 20 = 87 40,000

The purchasing division, Division Y, can buy a similar unit from an outside supplier for 86. Therefore, Division Y would be unwilling to pay more than 86 per unit.

Transfer price Cost of buying from outside supplier = 86

The requirements of the two divisions are incompatible and no transfer will take place. 2. In this case, Division X has enough idle capacity to satisfy Division Ys demand. Therefore, there are no lost sales and the lowest acceptable price as far as the selling division is concerned is the variable cost of 60 per unit.

Transfer price 60

0 60 40,000

The purchasing division, Division Y, can buy a similar unit from an outside supplier for 74. Therefore, Division Y would be unwilling to pay more than 74 per unit.

Transfer price Cost of buying from outside supplier = 74

In this case, the requirements of the two divisions are compatible and a transfer hopefully will take place at a transfer price within the range:

60 Transfer price 74

Problem15-13 1. (a) The general rule of transfer pricing is that for the most efficient decision-making to be made from a group viewpoint, transfer prices should be set at marginal cost of the supplying division plus the opportunity cost to the group. Since Alpha division has external sales which utilise its entire production capacity, the contribution which it earns from external sales is the opportunity foregone if it transfers internally. For example a selling price of 20 per unit may include a variable (marginal) cost of 12 and a contribution earned of 8. (b) Alpha division is likely to have costs which it incurs for external sales which will not apply to internal transfers to another division. It may, for example, be able to save on transport costs and on packing costs when goods are transferred. If such costs make up 3 of variable cost, the contribution of 8 shown in (i) above can still be earned by Alpha division with a selling price of 17 instead of 20. 2. The use of a standard cost based transfer price is argued to be effective in that the supplying division is not allowed to pass on to the receiving division any inefficiencies in operation. Such inefficiencies are left as adverse variances at the supplying division. This is useful where the transfer price is being compared to any quotes from external suppliers in order to choose the most effective strategy from a group viewpoint. The supplying division may, however, be faced with cost increases due to permanent and non-controllable changes from the original standards. For example, the level of material usage may have been underestimated or the wage rates finally agreed may have been understated. Such permanent changes may be reported as planning variances and incorporated into a revised standard. This revised standard will reflect current efficient costs at the supplying division. In this way the transfer price reflects current efficient costs to the group and the residual operational variances are reported and controlled at the supplying division. If properly explained, the receiving division is likely to accept this approach to transfer pricing. The use of actual cost plus a profit mark-up would maximise the reported profit at the supplying division but would not encourage cost control and could lead to suboptimal decisions by a receiving division to buy externally. 3. Where there is a shortage of the intermediate product, a linear programming model may be formulated centrally which incorporates all relevant information about selling prices and conversion costs of the four divisions which wish to use it in products for external sale. In addition, the marginal cost and the external opportunities (if any) of the intermediate product at one or all of the supplying divisions, will be built into the model. For example, it may be that one or more of the divisions has a partial external market for the intermediate product. The solution to the linear programming model will show to which divisions the available supplies of the intermediate product should be directed in order to maximise group profit. The model will also show the shadow price of the intermediate product which indicates its scarcity value. The shadow price shows the extent to which profits can be increased if one additional unit of the intermediate product is made available.

Exercise 14-9 (30 minutes) 1. ROI = Margin x Turnover (Net operating income/ Sales) x (Sales/ Average operating assets) Asia 600,000 x 12,000,000 12,000,000 3,000,000 = 5% 4 = 20%

Europe

560,000 x 14,000,000 14,000,000 7,000,000 = 4% 2 = 8%

North America

800,000 x 25,000,000 25,000,000 5,000,000 = 3.2% 5 Asia 3,000,000 14% 420,000 600,000 420,000 180,000 = 16% North Europe America 7,000,000 5,000,000 10% 16% 700,000 800,000 560,000 800,000 700,000 800,000 (140,000) -0North America 16%

2. Average operating assets Required rate of return Required operating income Actual operating income Required operating income (above) Residual income a. and b. 3. Return on investment (ROI) Therefore, if the division is presented with an investment opportunity yielding 15%, it probably would Minimum required return for computing residual income Therefore, if the division is presented with an investment opportunity yielding 15%, it probably would

Asia 20%

Europe 8%

Reject

Accept

Reject

14%

10%

16%

Accept

Accept

Reject

If performance is being measured by ROI, both the Asia and North American divisions probably would reject the 15 percent investment opportunity. The reason is that these divisions are presently earning a return greater than 15 percent; thus, the new investment would reduce the overall rate of return and place the divisional managers in a less favorable light. Europe probably would accept the 15 percent investment opportunity, since its acceptance would increase the divisions overall rate of return.

If performance is being measured by residual income, both Asia and Europe probably would accept the 15 percent investment opportunity. The 15 percent rate of return promised by the new investment is greater than their required rates of return of 14 percent and 10 percent, respectively, and would therefore add to the total amount of their residual income. North America would reject the opportunity, since the 15 percent return on the new investment is less than its 16 percent required rate of return. Exercise 15-7 (15 minutes) Division A 1. Sales Less expenses: Added by the division Transfer price paid Total expenses Net income
1 2

Division B 1,200,0002 400,000 500,000 900,000 300,000

2,500,0001 1,800,000 1,800,000 700,000

Total Company 3,200,0003 2,200,000 2,200,000 1,000,000

20,000 units X 125 = 2,500,000. 4,000 units X 300 = 1,200,000. 3 Division A outside sales (16,000 units x 125) Division B outside sales (4,000 units x 300) Total outside sales Notice that the 500,000 in intra-company sales has been eliminated.

2,000,000 1,200,000 3,200,000

2. Division A should transfer the 1,000 additional circuit boards to Division B. Note that Division Bs processing adds 175 to each unit in selling price (Bs 300 selling price, less As 125 selling price = 175 increase), yet adds only 100 in costs. Therefore, each board transferred to Division B ultimately yields 75 more in contribution margin (175 added revenue, less 100 added expense = 75 added contribution margin) to the company than can be obtained from selling to outside customers at the intermediate market stage. Thus, the company as a whole will be better off if Division A transfers the 1,000 additional boards to Division B.