ABMC3084 Information for control and decision making

Tutorial 11: Divisional Performance & Transfer Pricing

Question 1:
Division Z is part of P Bhd. It currently has net assets of RM5 million and makes an
annual profit of RM1 million. Its cost of capital is 8%.
The division's manager is considering an investment which will involve RM2.5
million expenditure on fixed assets and generate a net profit of RM250,000.
Required:

(a) Calculate the return on investment under the current situation and assuming
that the investment takes place. (Ans:ROI=20 %-Current arrangement
ROI=16.7 %-new investment)

(b) Calculate the residual income under the current situation and assuming that the
investment takes place. (Ans:RI=RM0.6m-Current arrangement
RI=RM0.65m-new investment)

(c) Comment on the answers in part (a) and (b) above.

(d) Discuss FOUR (4) problems that may arise when comparing divisional
performance.

(e) Discuss FOUR (4) behavioral issues that may arise when performance
measurement is based only on return on investment.

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Question 2:
Nelson Bhd. has two divisions. The following information relates to the previous
year’s performance of the healthcare division:
RM (million)
Investment in non-current assets 3.0
Investment in working capital 2.0
Operating profit 1.0

The healthcare division is currently considering a project to produce a new healthcare

product. The estimated figures for the new project are:
RM (million)
Additional non-current assets required 1.5
Additional investment in working capital 0.7
Budgeted additional profit 0.395

Return on investment (ROI) is used to evaluate the divisional performance and

bonuses are paid if the actual ROI exceeds the target.

Required:
(a) Calculate the return on investment for the healthcare division both before and
after the new project. (Ans:ROI=20 %-Before new project
ROI=19.4 %-After new project)
(b) Calculate the residual income for the healthcare division both before and after
the new project, assuming the company’s cost of capital is 15%.
(Ans:RI=RM0.25m-Before new project
RI=RM0.315m-After new project)

(c) Using return on investment as a performance measure, determine whether the

healthcare divisional manager would want to undertake the new project.

(d) Explain how your answer would differ if residual income were used as a
performance measure instead of return on investment.

(e) Briefly explain THREE (3) weaknesses of using return on investment as a

performance measure.

(f) Explain how the use of residual income would help overcome one of the
weaknesses of using return on investment.
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Question 3
The ABC Division manufactures and sells a single product. Half of its products are
sold within the group and the other half is sold at RM2.25 per unit outside the group
to wholesalers. ABC Division has no opening and closing stock at the end of the
period.
Budgets for next year show:
Production: 240,000 units
RM
Variable costs 300,000
Fixed costs - Production 120,000
- Administration 40,000

Required:

(a) Prepare budgeted profit & loss statements if the ABC Division uses transfer
prices based on:
(i) Marginal cost (Ans:Loss=RM40,000)
(ii) Market price (Ans:Profit=RM80,000)
(iii) Negotiated price (20% is added to the full cost of product)
(Ans: Profit=RM62,000)

(b) Explain with reasons which of the above transfer prices that the group would
recommend to be used for such transfers.
(c) Evaluate the profit or loss for the ABC Division if it continues with outside
sales at the present level but refuses to sell within the group.

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Question 4:
Division A is an investment centre which manufactures a single product that is fully
transferred to another investment centre within the same group. The following are the
budgeted information for Division A for the coming period:
Sales 6,000 units
Variable costs RM40 per unit
Fixed costs: Production RM200,000
Administration RM60,000
Capital employed RM700,000

Required:
(a) Prepare budgeted profit/loss statements for the coming period if Division A uses
internal transfer prices based on:
(i) Full cost plus 20%; and (Ans:Profit=RM100,000)
(ii) Market price of RM105 per unit. (Ans:Profit=RM130,000)

(b) Calculate the profit required for Division A to achieve a ROCE (return on
capital employed) of 20%. (Ans:Profit=RM140,000)
(c) Calculate the total contribution required to achieve a ROCE of 20%.
(Ans: Contribution= RM400,000)

(d) Calculate the transfer price Division A would have to charge to ensure its ROCE
is 20%. (Ans: Transfer price=RM106.67)
(e) If the transfer price of Division A is RM105, calculate:
(i) The breakeven sales in units; (Ans: BEP=4,000 units)

(ii) The profit/loss if sales are 5,000 units; and (Ans: Profit=RM65,000)

(iii) The residual income, assuming a cost of capital of 8% and sales volume is
5,000 units. (Ans: RI=RM9,000)

(f) Discuss THREE (3) advantages and THREE (3) disadvantages of using ROCE
to measure the performance of a division.