Class cases Ch 11

Ex.1, 2, and 7; E 11A-1 and 11A-2

EXERCISE 11-1 Compute the Return on Investment (ROI

Tundra Services Company, a division of a major oil company, provides various services to the
operators of the North Slope oil field in Alaska. Data concerning the most recent year appear
below:

Required:

1. Compute the margin for Tundra Services Company.

2. Compute the turnover for Tundra Services Company.

3. Compute the return on investment (ROI) for Tundra Services Company.

Answer for Exercise 11-1

1. Net operating income

Margin =
Sales
$5,400,000
= = 30%
$18,000,000

2. Sales
Turnover =
Average operating assets

$18,000,000
= = 0.5
$36,000,000

3. ROI = Margin × Turnover

= 30% × 0.5 = 15%

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EXERCISE 11-2 Residual Income
Midlands Design Ltd. of Manchester, England, is a company specializing in providing design
services to residential developers. Last year the company had net operating income of £400,000
on sales of £2,000,000. The company's average operating assets for the year were £2,200,000
and its minimum required rate of return was 16%. (The currency in the United Kingdom is the
pound, denoted by £.)

Required:

Compute the company's residual income for the year.

Answer for Exercise 11-2

Average operating assets ...................... £2,200,000

Net operating income ............................ £400,000
Minimum required return:
16% × £2,200,000 ............................. 352,000
Residual income.................................... £ 48,000

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EXERCISE 11-7 Contrasting Return on Investment (ROI) and Residual
Income
Rains Nickless Ltd. of Australia has two divisions that operate in Perth and Darwin. Selected
data on the two divisions follow:

Required:

1. Compute the return on investment (ROI) for each division.

2. Assume that the company evaluates performance using residual income and that the
minimum required rate of return for any division is 16%. Compute the residual income for
each division.

3. Is the Darwin Division's greater residual income an indication that it is better managed?
Explain

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Answer for Exercise 11-7
1. ROI computations:
Net operating income Sales
ROI = ×
Sales Average operating assets
$630,000 $9,000,000
Perth: × = 7% × 3 = 21%
$9,000,000 $3,000,000
$1,800,000 $20,000,000
Darwin: × = 9% × 2 = 18%
$20,000,000 $10,000,000

2. Perth Darwin
Average operating assets .................... $3,000,000 $10,000,000
Net operating income ......................... $630,000 $1,800,000
Minimum required return on average
operating assets—16% × Average
operating assets .............................. 480,000 1,600,000
Residual income ................................. $150,000 $ 200,000

3. No, the Darwin Division is simply larger than the Perth Division and for
this reason one would expect that it would have a greater amount of
residual income. Residual income can’t be used to compare the
performance of divisions of different sizes. Larger divisions will almost
always look better. In fact, in the case above, Darwin does not appear to
be as well managed as Perth. Note from Part (1) that Darwin has only
an 18% ROI as compared to 21% for Perth.

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EXERCISE 11A-1 Transfer Pricing Situations

In each of the cases below, assume that Division X has a product that can be sold either to
outside customers or to Division Y of the same company for use in its production process. The
managers of the divisions are evaluated based on their divisional profits.

Required:

1. Refer to the data in case A above. Assume that $3 per unit in variable selling costs can be
avoided on intracompany sales. If the managers are free to negotiate and make decisions on
their own, will a transfer take place? If so, within what range will the transfer price fall?
Explain.

2. Refer to the data in case B above. In this case, there will be no savings in variable selling
costs on intracompany sales. If the managers are free to negotiate and make decisions on their
own, will a transfer take place? If so, within what range will the transfer price fall? Explain.

Answer for Exercise 11A-1

1. The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
on lost sales
Transfer price ³ Variable cost +
per unit Number of units transferred
There is no idle capacity, so each of the 20,000 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 (= $50 – $30).

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 $20 × 20,000
Transfer price ³ ($30 - $2) +
20,000
= $28 + $20 = $48
The buying division, Division Y, can purchase a similar unit from an
outside supplier for $47. Therefore, Division Y would be unwilling to pay
more than $47 per unit.
Transfer price £ Cost of buying from outside supplier = $47
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 Y’s
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
$20 per unit.
$0
Transfer price ³ $20+ =$20
20,000
The buying division, Division Y, can purchase a similar unit from an
outside supplier for $34. Therefore, Division Y would be unwilling to pay
more than $34 per unit.
Transfer price £ Cost of buying from outside supplier = $34
In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:
$20 £ Transfer price £ $34

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EXERCISE 11A-2 Transfer Pricing from Viewpoint of the Entire Company

Division A manufactures picture tubes for TVs. The tubes can be sold either to Division B of the
same company or to outside customers. Last year, the following activity was recorded in
Division A:

Sales to Division B were at the same price as sales to outside customers. The tubes purchased by
Division B were used in a TV set manufactured by that division. Division B incurred $300 in
additional variable cost per TV and then sold the TVs for $600 each.

Required:

1. Prepare income statements for last year for Division A, Division B, and the company as a
whole.

2. Assume that Division A's manufacturing capacity is 20,000 tubes per year. Next year,
Division B wants to purchase 5,000 tubes from Division A, rather than only 4,000 tubes as in
last year. (Tubes of this type are not available from outside sources.) From the standpoint of
the company as a whole, should Division A sell the 1,000 additional tubes to Division B, or
should it continue to sell them to outside customers? Explain

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ANSWER FOR Exercise 11A-2

1. Total
Division A Division B Company
1 2 3
Sales ............................ $3,500,000 $2,400,000 $5,200,000
Expenses:
Added by the division . 2,600,000 1,200,000 3,800,000
Transfer price paid...... — 700,000 —
Total expenses .............. 2,600,000 1,900,000 3,800,000
Net operating income .... $ 900,000 $ 500,000 $1,400,000
1
20,000 units × $175 per unit = $3,500,000.
2
4,000 units × $600 per unit = $2,400,000.
3
Division A outside sales (16,000 units × $175 per unit) .. $2,800,000
Division B outside sales (4,000 units × $600 per unit) .... 2,400,000
Total outside sales ....................................................... $5,200,000
Observe that the $700,000 in intra-company sales has been eliminated.

2. Division A should transfer the 1,000 additional units to Division B. Note

that Division B’s processing adds $425 to each unit’s selling price (B’s
$600 selling price, less A’s $175 selling price = $425 increase), but it
adds only $300 in cost. Therefore, each tube transferred to Division B
ultimately yields $125 more in contribution margin ($425 – $300 =
$125) to the company than can be obtained from selling to outside
customers. Thus, the company as a whole will be better off if Division A
transfers the 1,000 additional tubes to Division B.