Question

6. RETURN ON INVESTMENT VS RESIDUAL INCOME AND TRANSFER PRICING   

Part A

The Checkers Ltd produces a wide variety of sports equipment. Its newest division, Golf Technology, manufactures and sells a single product—AccuDriver, a golf club that uses global positioning satellite technology to improve the accuracy of golfers’ shots. The demand for AccuDriver is relatively insensitive to price changes. The following data are available for Golf Technology, which is an investment centre for Sports Equipment:

Total annual fixed costs                                                          $26 000 000

Variable cost per AccuDriver                                                  $600

Number of AccuDrivers sold each year                                   170 000 clubs

Average operating assets invested in the division                    $46 000 000

Required

1. Calculate The Checkers Ltd ROI if the selling price of AccuDrivers is $830 per club.

2. If management requires an ROI of at least 28% from the division, what is the minimum selling price that the Golf Technology Division should charge per AccuDriver club?                                                                                                     
3. Assume that The Checkers Ltd judges the performance of its investment centres on the basis of RI rather than ROI. What is the minimum selling price that Sports Equipment should charge per AccuDriver unit to achieve a $4 820 000 residual income if the company’s required rate of return is 18%?                                                    

Part B

Sampson Ltd has two divisions. The Forming Division produces moulds, which are then transferred to the Finishing Division. The moulds are further processed by the Finishing Division and are sold to customers at a price of $300 per unit. The Forming Division is currently required by Sampson Ltd to transfer its total yearly output of 100 000 moulds to the Finishing Division at 120% of full manufacturing cost. Unlimited numbers of moulds can be purchased and sold on the outside market at $180 per unit.

The following table gives the manufacturing cost per unit in the Forming and Finishing divisions for 2019:

	Forming Division	Finishing Division
Direct materials cost	$24	$12
Direct manufacturing labour cost	17	20
Manufacturing overhead cost	64a	50b
Total manufacturing cost per unit	$105	$82

^aManufacturing overhead costs in the Forming Division are 20% fixed and 80% variable.

^bManufacturing overhead costs in the Finishing Division are 65% fixed and 35% variable.

Required

1. Calculate the operating profits for the Forming and Finishing divisions for the 100 000 moulds transferred under the following transfer-pricing methods: (a) market price and (b) 120% of full manufacturing cost.

2. Suppose that Sampson Ltd rewards each division manager with a bonus, calculated as 2% of division operating profit (if positive). What is the amount of bonus that will be paid to each division manager under the transfer-pricing methods in requirement 1? Which transfer-pricing method will each division manager prefer to use?

3. What arguments would Scott Devon, manager of the Forming Division, make to support the transfer-pricing method that he prefers?

(Total: 20 marks)

Answer 1

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