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# Raw Materials Budget Formula

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```									Exercise 11-7:          Contrasting Return on Investment (ROI) and Residual Income (RI)
Given:
Rains Nickless Ltd. Of Australia has two divisions that operate in Perth and Darwin. Selected
data on the two divisions follow:
Division
Perth         Darwin
Sales                                       \$9,000,000 \$20,000,000
Net operating income                          \$630,000      \$1,800,000
Average operating assets                    \$3,000,000 \$10,000,000

Required:
1. Compute the ROI for each division.

a. ROI = Net operating income / Average operating assets

b. ROI = margin X turnover
ROI = (Net operating income / Sales) X (Sales / Average operating assets)

Division
Perth          Darwin
Margin                    7%               9%
Turnover                   3                2
b.         ROI                      21%              18%
a.         ROI                      21%              18%

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

RI = Net operating income - Charge for use of capital
RI = Net operating income - (Average operating assets X Minimum required rate of return)

Division
Perth         Darwin
Minimum required rate of return             16%             16%
Net operating income                       \$630,000      \$1,800,000
Charge for use of capital                 (\$480,000) (\$1,600,000)
Residual income                            \$150,000        \$200,000

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

No, the Darwin Division is simply larger than the Perth Division and for this reason alone one
would expect that it would have a greater amount of residual income. In fact, based on the
data above, the Darwin Division does not appear to be as well managed as the Perth Division.
The Darwin Division has an 18% return on investment as compared to 21% for the Perth
Division.

Residual income can not be used to compare the performance of divisions of different sizes.
Larger divisions will almost always look better.
rth Division.
Exercise 11-9          Evaluating New Investment Using ROI and Residual Income (RI)
Given:
Selected sales and operating data for three divisions of three different companies are
given below:

Division A      Division B    Division C    Company
Sales                                      \$6,000,000      \$10,000,000   \$8,000,000   \$24,000,000
Average operating assets                   \$1,500,000       \$5,000,000   \$2,000,000    \$8,500,000
Net operating income                         \$300,000         \$900,000     \$180,000    \$1,380,000
Minimum required rate of return               15%              18%          12%

Required:
1. Compute the ROI for each division, using the formula stated in terms of margin and turnover.

a. ROI = Net operating income / Average operating assets

b. ROI = margin X turnover

ROI = (Net operating income / Sales) X (Sales / Average operating assets)

Division A      Division B    Division C   Company
Margin                              5.00%           9.00%         2.25%        5.75%
Turnover                              4.0             2.0           4.0        2.824
b. ROI                                20.00%          18.00%         9.00%       16.24%
a. ROI                                20.00%          18.00%         9.00%       16.24%

2. Compute the residual income for each division.

RI = Net operating income - Charge for use of capital

RI = Net operating income - (Average operating assets X Minimum required rate of return)

Division A      Division B  Division C
Net operating income                      \$300,000        \$900,000    \$180,000
Charge for use of capital                (\$225,000)      (\$900,000)  (\$240,000)
Residual income                            \$75,000               \$0   (\$60,000)

3. Assume that each division is presented with an investment opportunity that would yield a
rate of return of 17%.
a. If performance is being measured by ROI, which division or divisions will probably accept
the opportunity? Reject? Why?
Division A Division B    Division C
Current ROI                                 20%        18%            9%
Investment opportunity return               17%        17%           17%
Effect on ROI if opportunity is accepted Decrease   Decrease       Increase
Accept or reject decision                  Reject     Reject        Accept

b. If performance is being measured by RI, which division or divisions will probably accept
the opportunity? Reject? Why?

Division A      Division B    Division C
Current RI                                \$75,000       \$0      (\$60,000)
Investment opportunity return               17%        17%        17%
Minimum required rate of return             15%        18%        12%
Effect on RI if opportunity is accepted   Increase   Decrease   Increase
Accept or reject decision                  Accept     Reject     Accept
Exercise 11-12          Effects of Changes in Profits and Assets on Return on Investment
Given:
The Abs Shoppe is a regional chain of health clubs. The managers of the clubs, who have
authority to make investments as needed, are evaluated based largely on ROI. The Abs Shoppe
reported the following results for the past year:
Abs
Shoppe
Sales                                          \$800,000
Net operating income                            \$16,000
Average operating assets                       \$100,000

Required:
The following questions are to be considered independently. Carry out all computations to two
decimal places.
1. Compute the club's ROI

a. ROI = Net operating income / Average operating assets

b. ROI = margin X turnover
ROI = (Net operating income / Sales) X (Sales / Average operating assets)

Abs
Shoppe
Margin                   2.00%
Turnover                  8.00
b.        ROI                     16.00%
a.        ROI                     16.00%

2. Assume that the manager of the club is able to increase sales by \$80,000 and that as a result
net operating income increases by \$6,000. Further assume that this is possible without any
increase in operating assets. What would be the club's ROI?

Original      Changes         New
Sales                                       \$800,000        \$80,000      \$880,000
Net operating income                         \$16,000         \$6,000       \$22,000
Average operating assets                    \$100,000             \$0      \$100,000

Abs                         Abs
Shoppe                      Shoppe
Margin        2.00%                       2.50%
Turnover       8.00                        8.80
ROI          16.00%                      22.00%
ROI          16.00%                      22.00%

3. Assume that the manager of the club is able to reduce expenses by \$3,200 without any
change in sales or operating assets. What would be the club's ROI?

Original      Changes         New
Sales                                       \$800,000             \$0      \$800,000
Net operating income                         \$16,000         \$3,200       \$19,200
Average operating assets                    \$100,000             \$0      \$100,000
Abs                        Abs
Shoppe                     Shoppe
Margin        2.00%                      2.40%
Turnover       8.00                       8.00
ROI          16.00%                     19.20%
ROI          16.00%                     19.20%

4. Assume that the manager of the club is able to reduce operating assets \$20,000 without any
change in sales or net operating income. What would be the club's ROI?

Original     Changes         New
Sales                                      \$800,000             \$0     \$800,000
Net operating income                        \$16,000             \$0      \$16,000
Average operating assets                   \$100,000       (\$20,000)     \$80,000

Abs                        Abs
Shoppe                     Shoppe
Margin        2.00%                      2.00%
Turnover       8.00                      10.00
ROI          16.00%                     20.00%
ROI          16.00%                     20.00%
Problem 11-19:      Perverse effects of some performance measures

Given:
There is often more than one way to improve a performance measure. Unfortunately, some of the actions
taken by managers to make their performance look better, may actually harm the organization. For example,
suppose the marketing department is held responsible only for increasing the performance measure
"total revenues." Increases in total revenues may be achieved by working harder and smarter, but they can
also usually be achieved by simply cutting prices. The increase in volume from cutting prices almost always
results in greater total revenues; however, it does not always lead to greater total profits. Those who
design performance measurement systems need to keep in mind, the managers who are under pressure to
perform may take actions to improve performance measures that have negative consequences elsewhere.

Required:

For each of the following situations, describe actions that managers might take to show improvement
in the performance measure but which do not actually lead to improvement in the organization's overall
performance.

The answers below are not the only possible answers. Ingenious people can figure out many different
ways of making performance look better even though it really isn't. This is one of the reasons for a
balanced scorecard. By having a number of different measures that ultimately are linked to overall
financial goals, "gaming" the system is more difficult.

1. Concerned with the slow rate at which new products are brought to market, top management of a
consumer electronics company introduces a new performance measure -- speed-to-market. The
research and development department is given responsibility for this performance measure, which
measures the average amount of time a product is in development before it is released to the market
for sale.

Speed-to-market can be improved by taking on less ambitious projects. Instead of working on major
product innovations that require a great deal of time and effort, R&D may choose to work on small,
incremental improvements in existing products. There is also a danger that in the rush to push products
out the door, the products will be inadequately tested and developed.

2. The CEO of a telephone company has been under public pressure from city officials to fix the
large number of public pay phones that do not work. The company's repair people complained that the
the problem is vandalism and damage caused by theft of coins from calling boxes -- particularly in
high-crime areas in the city. The CEO says she wants the problem solved and has pledged to city
officials that there will be substantial improvement by the end of the year. To ensure that this is
done, she makes the managers in charge of installing and maintaining pay phones responsible for
increasing the percentage of public pay phones that are fully functional.

Performance measures that are ratios or percentages present special dangers. A ratio can be increased
either by increasing the numerator or decreasing the denominator. Usually, the intention is to increase
the numerator in the ratio, but a manager may react by decreasing the denominator instead. In this case
(which actually happened), the managers pulled telephones out of the high-crime areas. This eliminated
the problem for the managers, but was not what the CEO or the city officials had intended. They wanted
the phones fixed, not eliminated.

3. A manufacturing company has been plagued by the chronic failure to ship orders to customers by
the promised do date. To solve this problem, the production manager has been given the responsibility
of increasing the percentage of orders shipped on time. When a customer calls in an order, the
production manager and the customer agreed to a delivery date. If the order is not completed by
that day, it is counted as a late shipment.

In real life, the production manager simply added several weeks to the delivery cycle time. In other words,
instead of promising to deliver an order in four weeks, the manager promise to deliver in six weeks. This
increase in delivery cycle time did not, of course, please customers and drove some business away, but
it dramatically improved the percentage of orders delivered on time.

4. Concerned with the productivity of employees, the Board of Directors of a large multinational corporation
has dictated that the manager of each subsidiary will be held responsible for increasing the revenue per
employee of his or her subsidiary.

As stated above, ratios can be improved by changing either the numerator or the denominator. Managers
who are under pressure to increase the revenue per employee may find it easier to eliminate employees
than to increase revenues. Of course, eliminating employees may reduce total revenues and total
profits, but the revenue per employee will increase as long as the percentage decline in revenues is less
than the percentage cut in number of employees.

Suppose, for example, that a manager is responsible for business units with a total of 1,000 employees,
\$120 million in revenues, and profits of \$2 million. Further suppose that a manager can eliminate one of
these business units that has 200 employees, revenues of \$10 million, and profits of \$1.2 million.

Before             After
Eliminating       Eliminating
Unit             Unit
Total revenue                            \$120,000,000      \$110,000,000
Total employees                                  1,000               800
Revenue per employee                         \$120,000          \$137,500
Total profits                              \$2,000,000          \$800,000

As these examples illustrate, performance measures should be selected with a great deal of care.
Managers should avoid placing too much emphasis on any one performance measure.
Problem 11-22      Internal Business Process Performance Measures

Given:
Exeter Corporation has recently begun a continuous improvement campaign. As a consequence, there have been
many changes in operating procedures. Progress has been slow, particularly in trying to develop new performance
measures for the factory.

Management has been gathering the following data over the past four months:

Months
Quality control measures:                              1                 2                3                4
Customer complaints as a % of units sold                1.40%             1.30%            1.10%            1.00%
Warranty claims as a % of units sold                    2.30%             2.10%            2.00%            1.80%
Defects as a % of units produced                        4.60%             4.20%            3.70%            3.40%
Material control measures:
Scrap as a % of total cost                              3.20%             2.90%            3.00%            2.70%
Machine performance measures:
Break-even point: 400 persons,
Percentage of machine availability         or            80%               82%            Total Expenses
Fixed Expenses 79%
Total Sales
81%
Use as a percentage of availability                      75%               73%              71%              70%
Average setup time (hours)                                2.7               2.5              2.5              2.6
Delivery performance measures:
Throughput time                                            ?                 ?                ?                ?
Manufacturing cycle efficiency                             ?                 ?                ?                ?
Delivery cycle time                                        ?                 ?                ?                ?
Percentage of on-time deliveries                         84%               87%              91%              95%

The president has attended conferences at which the importance of throughput time, manufacturing cycle efficiency,
and delivery cycle time were stressed, but no one at the company is sure how they are computed. The data to
compute these measures have been gathered and appear below:
Months
1                2               3                4
Wait time/order before production (in days)                 16.7              15.2            12.3               9.6
Inspection time per unit (in days)                           0.1               0.3             0.6               0.8
Process time per unit (in days)                              0.6               0.6             0.6               0.6
Queue time per unit (in days)                                5.6               5.7             5.6               5.7
Move time per unit (in days)                                 1.4               1.3             1.3               1.4

Required:
1. For each month, compute the following operating performance measures:
a. Throughput time (manufacturing cycle time)
Months
1              2                        3                4
Process time                                   0.6           0.6                       0.6               0.6
Inspection time                                0.1           0.3                       0.6               0.8
Move time                                      1.4           1.3                       1.3               1.4
Queue time                                     5.6           5.7                       5.6               5.7
Throughput time                             7.7           7.9                       8.1               8.5

MCE = (Process time) / (Throughput time)

Months
1                  2                 3                 4
Process time                                           0.6                0.6               0.6               0.6
Throughput time                                        7.7                7.9               8.1               8.5
MCE =             7.79%              7.59%             7.41%             7.06%

c. Delivery cycle time = Wait time + Throughput time
Months
1                  2                 3                 4
Wait time                                             16.7               15.2              12.3               9.6
Throughput time                                        7.7                7.9               8.1               8.5
Delivery cycle time =                     24.40              23.10             20.40             18.10

2. Using the performance measures given in the problem and those you computed in (1) above, do the following:

a. Identify areas where the company seems to be improving.

The company seems to be improving mainly in the areas of quality control, material control, on-time delivery,
and total delivery cycle time. Customer complaints, warranty claims, defects, and scrap are all down somewhat,
which suggests that the company has been paying attention to quality in its improvement campaign. The fact
that on-time delivery and delivery cycle time have both improved also suggests that the company is seeking to
please the customer with improved service.

b. Identify areas where the company seems to be deteriorating or stagnating.

Inspection time has increased dramatically. "Use as % of availability" has deteriorated, and throughput time as
well as manufacturing cycle efficiency (MCE) show negative trends.

c. Explain why you think some specific areas are improving while others are not.

While it is difficult to draw any definitive conclusions, it appears that the company has concentrated first on
those areas of performance that are of most immediate concern to the customer -- quality and delivery
performance. The lower scrap and defect statistics suggest that the company has been able to improve its
processes to reduce the rate of defects; although, some of the improvement in quality apparently was due
simply to increased inspections of the products before they were shipped to customers.

3. Refer to the move time, process time, and so forth, given above for month 4.

a. Assume that in month 5 the move time, process time, and so forth, are the same as for
month 4, except that through the implementation of lean production, the company is able to
completely eliminate the queue time during production. Compute the new throughput time
and manufacturing cycle efficiency (MCE).

b. Assume that in month 6 the move time, process time, and so forth, are the same as for
month 4, except that the company is able to completely eliminate both the queue time
during production and the inspection time. Compute the new throughput time and MCE.

Months
Throughout time in days:                           5                  6
Process time                                           0.6                0.6
Inspection time                                        0.8                0.0
Move time                                              1.4                1.4
Queue time                                          0.0               0.0
Total throughput time                             2.8               2.0

Manufacturing cycle efficiency (MCE)
Process time                                        0.6               0.6
Throughput time                                     2.8               2.0
MCE =           21.43%            30.00%

As non-value-added activities are eliminated, the manufacturing cycle efficiency improves. The goal, of
course, is to have an efficiency of 100%. This is achieved when all non-value added activities have been
eliminated and process time equals throughput time.
e following:

mewhat,
Exercise 11B-3        Service Department Charges

Given:
Gutherie Oil Company has a Transport Services Department that provides trucks to transport crude
oil from docks to the company's Arbon Refinery and Beck Refinery. Budgeted costs for the transport
services consist of \$0.30 per gallon variable cost and \$200,000 fixed cost. The level of fixed cost is
determined by peak-period requirements. During the peak period, Arbon Refinery requires 60% of
the capacity and the Beck Refinery requires 40%.

During the year, the Transport Services Department actually hauled the following amounts of crude
oil for the two refineries: Arbon Refinery, 260,000 gallons; and Beck Refinery, 140,000 gallons. The
Transport Services Department incurred \$365,000 in cost during the year, of which \$148,000 was
variable cost and \$217,000 was fixed cost.

Most common method of allocation:

Actual Variable Cost Incurred                                    \$148,000
Variable cost per gallon hauled              \$0.3700
Actual Fixed Costs Incurred                                      \$217,000
Total Costs Incurred                                             \$365,000

Gallon hauled by Transport Services:
Hauled to Arbon Refinery                                       260,000
Hauled to Beck Refinery                                        140,000
Total gallons hauled                                       400,000

Average cost per gallon hauled:                                   \$0.9125

Arbon            Beck            Total
Allocation: actual gallons X actual rate                        \$237,250        \$127,750        \$365,000

Problems:
1. Efficiencies and inefficiencies of service departments are passed on to production departments.
2. The operations of one production department affect the other departments.

Break-even point: 400
Required:                                                        Total Expenses
Fixed Expenses
Total Sales
1. Determine how much of the \$148,000 in variable cost should be charged to each refinery.
2. Determine how much of the \$217,000 in fixed cost should be charged to each refinery.

Arbon            Beck            Total
Peak period capacity needs                                      60%          40%         100%
Budgeted fixed costs                   \$200,000
Budgeted variable (\$.30/gallon)           \$0.30

Allocation of Variable Costs:                           Arbon            Beck            Total
Allocation: actual gallons X budgeted rate                 \$78,000        \$42,000        \$120,000
Allocation of Fixed Costs:
Allocation: Peak period % X budgeted FC                    120,000         80,000         200,000
Total Costs Allocated                                  \$198,000       \$122,000        \$320,000
3. Will any of the \$365,000 in the Transport Services Department cost not be charged to the
refineries?
Variable Costs Fixed Costs         Total
Total Transport Services Department Costs Incurred           \$148,000      \$217,000      \$365,000
Total Transport Services Department Costs Assigned           \$120,000       200,000      \$320,000
Total Transport Services Department Costs Unassigned          \$28,000       \$17,000       \$45,000

The overall spending variance of \$45,000 represents costs incurred in excess of the budgeted \$.30
per gallon variable cost and budgeted \$200,000 in fixed costs. This \$45,000 in unallocated cost is
the responsibility of the Transport Services Department.
Exercise 11B-2         Sales Dollars as an Allocation Base for Fixed Costs
Given:
Lacey's Department Store allocates its fixed administrative expenses to its four operating
departments on the basis of sales dollars. During 2009, the fixed administrative expenses
totaled \$900,000. These expenses were allocated as follows:

Men's        Women's        Shoes    Housewares
Total sales -- 2009                             \$600,000     \$1,500,000   \$2,100,000  \$1,800,000
Percentage of total sales                            10%            25%          35%         30%

Allocation (based on the above percentages)      \$90,000      \$225,000      \$315,000         \$270,000

During 2010, the following year, the Women's Department doubled its sales. The sales levels in the
other three departments remained unchanged. The company's 2010 sales data were as follows:

Men's        Women's        Shoes    Housewares
Total sales -- 2010                             \$600,000     \$3,000,000   \$2,100,000  \$1,800,000
Percentage of total sales                             8%            40%          28%         24%

Fixed administrative expenses remained unchanged at \$900,000 during 2010.                    \$900,000

Required:
1. Using sales dollars as an allocation base, show the allocation of the fixed administrative expenses
among the four departments for 2010.

Men's        Women's        Shoes      Housewares
Allocation for 2010     \$72,000       \$360,000      \$252,000      \$216,000

2. Compare your allocation from (1) above to the allocation for 2009. As the manager of the Women's
Department, how would you feel about the administrative expenses that have been charged to you
you for 2010?

Men's        Women's        Shoes     Housewares
Allocation for 2010      \$72,000      \$360,000      \$252,000     \$216,000
Allocation for 2009      \$90,000      \$225,000      \$315,000     \$270,000
Increase/Decrease       (\$18,000)     \$135,000      (\$63,000)    (\$54,000)

The manager of the Women's Department undoubtedly will be upset about the increased allocation
to the department but will feel powerless to do anything about it. Such an increased allocation may be
viewed as a penalty for an outstanding performance.

Note: The allocations to all of the other departments decreased.

3. Comment on the usefulness of sales dollars as an allocation base.

Sales dollars is not ordinarily a good base for allocating fixed costs. The costs allocated to a
department will be affected by the sales in other departments. In other words, how much fixed
costs will be allocated to one department depends on the operations of another department.
Note that if the department managers have bonus plans based on NOI, these managers will receive
bonus increases because of the increased sales in the Women's Department.
Total
\$6,000,000
100%

\$900,000

Total
\$7,500,000
100%

ve expenses

Total
\$900,000

the Women's
arged to you

Total
\$900,000
\$900,000
\$0

ed allocation
llocation may be

Problem 11A-5 Basic Transfer Pricing
Given:
In cases 1-4 below, assume that Division A has a product that can be sold either to Division B of the same
company or to outside customers. The managers of both divisions are evaluated based on their own
division's ROI. The managers are free to decide if they will participate in any internal transfers. All transfer
prices are negotiated. Treat each case independently.
Cases
1             2             3              4
Division A:
Capacity in Units                                                  50,000      300,000       100,000         200,000
Number of units now being sold to outside customers                50,000      300,000        75,000         200,000
Excess Capacity or Full Capacity                                  Full          Full       Excess            Full
Selling price per unit to outside customers                         \$100           \$40           \$60              \$45
Variable cost per unit                                                 63            19           35               30
Contribution per unit                                                \$37           \$21           \$25              \$15
Fixed costs per unit (based on capacity)                             \$25             \$8          \$17               \$6

Division B:
Number of units needed annually                                     10,000           70,000    20,000         60,000
Purchase price now being paid to an outside supplier                  \$92              \$39       \$60          -
Discounted purchase price being paid to an outside supplier                                      \$57
Before any purchase discount.

Required:
1. Refer to case 1 above. A study has indicated that Division A can avoid \$5 per unit in variable costs on
any sales to Division B. Will the managers agree to a transfer and if so, within what range will the
transfer price be? Explain.

Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = (\$63 - \$5) + (\$37 X 10,000)/10,000 = \$58 + \$37 = \$95

Division A:
Contribution margin per unit generated under the current situation                                               \$37 \$100 - 63
Contribution margin per unit generated if a transfer takes place at \$95/unit                                      37 \$95 - (\$63 - \$5)
Division A manager is indifferent to selling outside or transferring to Division B                                \$0

Division B:
Cost per unit if purchased outside                                                                               \$92
Cost per unit if transferred at \$95/unit                                                                          95
Division B manager would reject internal transfer because of \$3 per unit increase in cost                        (\$3)

The managers will not agree to a transfer.
Division A will not accept less than \$95 and
Division B will not pay more than \$92, the outside price.
There is no possible range of negotiation within which a transfer could take place.

2. Refer to case 2 above. Assume that Division A can avoid \$4 per unit in variable costs on any sales to
Division B.
a. Would you expect any disagreement between the two divisional managers over what the transfer
price should be? Explain.
Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = (\$19 - \$4) + (\$21 X 70,000)/70,000 = \$15 + \$21 = \$36

Division A:
Contribution margin per unit generated under the current situation                                              \$21 \$40 - \$19
Contribution margin per unit generated if a transfer takes place at \$36/unit                                     21 \$36 - (\$19 - \$4)
Division A manager is indifferent to selling outside or transferring to Division B                               \$0

Division B:
Cost per unit if purchased outside                                                                              \$39
Cost per unit if transferred at \$36/unit                                                                         36
Division B manager would accept an internal transfer because of a \$3 decrease in cost                            \$3

The managers should agree to a transfer.
Division A will be willing to accept a price of \$36 or higher
Division B will be willing to pay no more \$39, the outside price.
The range of negotiation within which a transfer should take place is \$39 to \$36.

Even though the company would be better off with any transfer price within this range, each manager
will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
hold out for a transfer price of \$39, while Division B's manager will try to hold out for a transfer price of
\$36 per unit transferred.

b. Assume that Division A offers to sell 70,000 units to Division B for \$38 per unit and that Division B
refuses this price. What will be the loss in potential profits for the company as a whole?

70,000 X \$3 =       \$210,000 Loss in potential profits

Proof:
Division A:
TP per unit to Division B                                                                                    \$38
Variable cost per unit associated with transfer                                                               15
Benefit per unit to Division A                                                                           \$23
Less CM given up to make transfer possible                                                                21
Net per unit benefit to Division A                                                                        \$2
Number of units transferred                                                                           70,000
Total increase in CM to Division A as a result of transfer                                              \$140,000

Division B:
Cost per unit if purchased outside                                                                           \$39
Cost per unit if transferred at agreed upon TP                                                                38
Benefit per unit to Division B                                                                            \$1
Number of units transferred                                                                           70,000
Total increase in CM to Division A as a result of transfer                                               \$70,000

Total benefit to the company resulting from the transfer                                                \$210,000

Note: Transfer price allocates profit between Division A and Division B.
3. Refer to case 3 above. Assume that Division B is now receiving a 5% price discount from the outside
supplier.
a. Will the managers agree to a transfer? If so, within what range will the transfer price be?

Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = \$35 + (\$0 X 20,000)/20,000 = \$35 + \$0 = \$35

Division A:
Contribution margin per unit generated under the current situation (excess capacity)                                    \$0
Contribution margin generated if a transfer takes place at \$35/unit                                                      0
Division A manager is indifferent to selling outside or transferring to Division B                                      \$0

Division B:
Cost per unit if purchased outside                                                                                      \$57
Cost per unit if transferred at \$35/unit                                                                                 35
Division B manager would accept an internal transfer because of a \$22 per unit decrease in cost                         \$22
\$440,000
The managers should agree to a transfer.
Division A will be willing to accept a price of \$35 or higher
Division B will be willing to pay no more \$57, the outside price.
The range of negotiation within which a transfer should take place is \$35 to \$57.

Even though the company would be better off with any transfer price within this range, each manager
will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
hold out for a transfer price of \$57, while Division B's manager will try to hold out for a transfer price of
\$35 per unit transferred.

b. Assume that Division B offers to purchase 20,000 units from Division A at \$52 per unit. If Division A
accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?

Benefit to company as a whole resulting from transfers                   20,000 X \$22 =                 \$440,000

Division A:
TP per unit to Division B                                                                                    \$52
Variable cost per unit associated with transfer                                                               35
Benefit per unit to Division A                                                                           \$17
Less CM given up to make transfer possible (excess capacity)                                               0
Net per unit benefit to Division A                                                                       \$17
Number of units transferred                                                                           20,000
Total increase in CM to Division A as a result of transfer                                              \$340,000

Effect on ROI: Divisional income will increase by \$340,000 with no change
in investment (excess capacity). Thus, Division A's ROI will increase.

Division B:
Cost per unit if purchased outside                                                                           \$57
Cost per unit if transferred at agreed upon TP                                                                52
Benefit per unit to Division B                                                                            \$5
Number of units transferred                                                                           20,000
Total increase in CM to Division A as a result of transfer                                              \$100,000
Total benefit to the company resulting from the transfer                                     \$440,000

Note: Transfer price allocates profit between Division A and Division B.

4. Refer to case 4 above. Assume that Division B wants Division A to provide it with 60,000 units of a
different product from the one that Division A is now producing. The new product would require \$25
per unit in variable costs and would require that Division A cut back production of its present product by
30,000 units annually. What is the lowest acceptable transfer price from Division A's perspective?

Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = \$25 + (\$15 X 30,000) / 60,000 = \$25 + (\$450,000 / 60,000) = \$25 + \$7.50 = \$32.50

Proof:
Division A:
Contribution margin generated under the current situation                                        \$450,000
Contribution margin generated if a transfer takes place at \$32.50 per unit                       \$450,000
Division A manager is indifferent to selling outside or transferring to Division B
at a TP of \$32.50.
- \$5)
- \$4)
Excess Capacity
\$35 - \$35

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