Question

Oxford Company has two divisions. Thames Division, which has an investment base of $81,000,000, produces and sells 910,000 units of a product at a market price of $149 per unit. Its variable costs total $40 per unit. The division also charges each unit $71 of fixed costs based on a capacity of 1,000,000 units.

Lakes Division wants to purchase 260,000 units from Thames. However, it is willing to pay only $82 per unit because it has an opportunity to accept a special order at a reduced price. The order is economically justifiable only if Lakes can acquire Thames’ output at a reduced price.

  

Division managers are evaluated using residual income using a 12 percent cost of capital

   

Required:

a. What is the residual income for Thames without the transfer to Lakes?

residual income

b. What is Thames’s residual income if it transfers 260,000 units to Lakes at $82 each?

residual income

c. What is the minimum transfer price for the 260,000-unit order that Thames would accept if it were willing to maintain the same residual income with the transfer as it would accept by selling its 910,000 units to the outside market? (Round your answer to 2 decimal places.)

minimum transfer price

Answer 1

Solution a:

Existing operating income of Thames = Contribution margin - Fixed costs

= 910000 * ($149 - $40) - (1000000*$71)

= $28,190,000

Minimum required income = Invested amount * Cost of capital = $81,000,000 * 12% = $9,720,000

Residual Income = $28,190,000 - $9,720,000 = $18,470,000

Solution b:

If Thames transfer 260000 units to lakes then it has to loose regular sale for 170000 units as thames is having capacity of 1000000 units only.

Therefore loss of contribution margin on 170000 units = 170000 * ($149 - $40) = $18,530,000

Contribution margin on transfer to lakes = 260000 * ($82 - $40) = $10,920,000

Net Loss from internal transfer = $10,920,000 - $18,530,000 = -$7,610,000

New residual income = Existing residual income - Net loss from internal transfer = $18,470,000 - $7,610,000 = $10,860,000

Solution c:

In order to maintain same residual income, thames need to collect $7,610,000 more on sale of 260000 units to Lakes

Therefore additional per unit revenue is required from lakes = $7,610,000 / 260000 = $29.27 per unit

Minimum transfer price per unit = $82 + $29.27 = $111.27