Problem 12-37 Return on Investment and Economic Value Added Calculations with Varying

Assumptions

Knitpix Products is a division of Parker Textiles Inc. During the coming year, it expects to earn income of
$310,000 based on sales of $3.45. Without any new investments, the division will have average
operating assets of $3 million. The division is considering a capital investment project – adding knittin g
machines to produce gaiters – that required an additional investment of $600,000 and increases net
income by $57,500 (sales would increase by $575,000). If made, the investment would increase
beginning operating assets by $600,000 and ending operating assets by $400,000. Assume that the
actual cost per capital for the company is 7%. (Answer with four decimal places.)

Required

1. Compute the ROI for the division without the investments

2. Compute the margin and turnover ratios without the investment. Show the product of the
margin and turnover ratios equals the ROI computed in Requirement 1.
3. Compute the ROI for the division with the new investment. Do you think the divisional manager
will approve the investment?
4. Compute the margin and turnover ratios for the division with the new investment. How do
these compare with the old ratios?
5. Compute the EVA of the division with and without the investment. Should the manager decide
to make knitting machine investment?

Problem 12-38 Transfer Pricing

GreenWorld Inc is a nursery product firm. It has three divisions that grow and sell plants: the Western
Division, the Southern Division, and the Canadian Division. Recently, the Southern Division of GreenWorl
d acquired a plastic factory that manufactures green plastic pots. These pots can be sold both externally
and internally. Company policy permits each manager to decide whether to buy or sell internally. Each
divisional manager is evaluated on the basis of ROI and EVA.

The western Division had bought its plastic pots in lots of 100 from variety of vendors. The average price
paid was 75 per box of 100 pots. However, the acquisition made Rosario Sanchez-Ruiz, manager of the
Western Division, wonder whether or not a more favourable price could be arranged. She decided to
approach Lorne Matthews, manager of the Southern Division, to see if he wanted to offer a better price
for internal transfer. She suggested a transfer of 3500 boxes at $70 per box.

Lorne gathered the following information regarding the cost of a box of 100 pots:

Direct Materials $35

Direct Labor $8
Variable overhead $10

Fixed Overhead $10

Total Unit Cost $63

*Fixed overhead is based on $200,000/20,000 boxes.

Selling price $75

Production Capacity 20,000 boxes

What is transfer pricing? : Transfer price represents the price of goods that are sold , or transferred,
between different division .

1. Conceptual Connection
a. Suppose that the plastic factory is producing at capacity and can sell all that it produces to
outside customers. How should Lorne respond to Rosario’s request for a lower they
transfer price?
Since the Southern Division is producing at capacity and can sell all it produces, Lorne
would refuse the offer of $70/box as Transfer Price. This is because Southern Division can
earn more profit by selling in the outside market for $75/box.

2. Conceptual Connection
a. Now assume that the plastic factory is currently selling 16,000 boxes. What are the
minimum and maximum transfer prices? Should Lorne consider the transfer at $70 per
box?

The minimum Transfer Price (Floor) = Total Variable Cosr.

= $53/box (35+8+10)

The maximum Transfer Price (Ceiling) = The maximun transfer price is the market price.
Price at the outside market = $ 75/box

Lorne should consider the Transfer Pricing at $ 70/box because it is higher amount than the
minimum transfer which is the cost and their current selling is now below capacity (16 000
boxes). The manufacturing full capacity is at 20 000. Lorne can utilised its manufaturing
capacity for another 3500 at 70 /box.