1. “I know headquarters wants us to add that new product line,” said Fred Halloway, manager of Kirsi Products’ East Division. “But I want to see the numbers before I make a move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.”

Kirsi Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company’s East Division for last year are given below:

Sales $ 26,000,000

Variable expenses 13,000,000

Contribution margin 13,000,000

Fixed expenses 10,920,000

Net operating income $ 2,080,000

Divisional operating assets $ 5,200,000

The company had an overall ROI of 18% last year (considering all divisions). The company’s East Division has an opportunity to add a new product line that would require an investment of $3,240,000. The cost and revenue characteristics of the new product line per year would be as follows:

Sales $ 10,044,000

Variable expenses 65% of sales

Fixed expenses $ 2,802,276

Required:

1. Compute the East Division’s ROI for last year; also compute the ROI as it would appear if the new product line is added. (Round your intermediate calculations and final answers to 2 decimal places. Omit the “%” sign in your response.)

2. Suppose that the company’s minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income.

Compute the East Division’s residual income for last year; also compute the residual income as it would appear if the new product line is added. (Omit the “$” sign in your response.)

2. Problem 11A-5 Basic Transfer Pricing [LO5]

In cases 1-3 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 return on investment (ROI). The managers are free to decide if they will participate in any internal transfers. All transfer prices are negotiated. Treat each case independently.

Case

1 2 3 4

Division A:

Capacity in units 51,000 298,000 101,000 202,000

Number of units now being sold to outside

customers 51,000 298,000 74,000 202,000

Selling price per unit to outside customers $101 $40 $69 $45

Variable costs per unit $65 $19 $42 $30

Fixed costs per unit (based on capacity) $24 $8 $27 $5

Division B:

Number of units needed annually 9,500 66,000 22,000 64,000

Purchase price now being paid to an outside

supplier* $92 $40 $69 —

* Before any purchase discount.

Required:

1. Refer to case 1. A study has indicated that Division A can avoid $6 per unit in variable costs on any sales to Division B.

a. What is the minimum transfer price for Division A?

b. What is the maximum transfer price for Division B?

c. Will the managers agree to a transfer?

2. Refer to case 2. Assume that Division A can avoid $3 per unit in variable costs on any sales to

Division B.

a-1. What is the minimum transfer price for Division A? (Omit the “$” sign in your response.)

a-2. What is the maximum transfer price for Division B? (Omit the “$” sign in your response.)

a-3. Would you expect any disagreement between the two divisional managers over what the transfer price should be?

b. Assume that Division A offers to sell 66,000 units to Division B for $39 per unit and that Division B refuses this price. What will be the loss in potential profits for the company as a whole? (Input the amount as a positive value. Omit the “$” sign in your response.)

3. Refer to case 3. Assume that Division B is now receiving a 6% price discount from the outside supplier.

a-1. What is the minimum transfer price for Division A?

a-2. What is the range of transfer price the manager’s of both divisions should agree?

a-3. Will the managers agree to a transfer?

b. Assume that Division B offers to purchase 22,000 units from Division A at $59.86 per unit. If Division A accepts this price, would you expect its ROI to increase, decrease, or remain unchanged?

4. Refer to case 4. Assume that Division B wants Division A to provide it with 64,000 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 32,000 units annually. What is the lowest acceptable transfer price from Division A’s perspective?