Question

1. Coolbrook Company has the following information available for the past year:   

	River Division			Stream Division
Sales revenue	$	1,205,000		$	1,812,000
Cost of goods sold and operating expenses		890,000			1,284,000
Net operating income	$	315,000		$	528,000
Average invested assets	$	1,120,000		$	1,520,000

   

The company’s hurdle rate is 6.76 percent.

Required:

1. Calculate return on investment (ROI) and residual income for each division for last year.

2. Recalculate ROI and residual income for the division for each independent situation that follows:

a. Operating income increases by 9 percent.

b. Operating income decreases by 10 percent.

c. The company invests $249,000 in each division, an amount that generates $101,000 additional income per division.

d. Coolbrook changes its hurdle rate to 4.76 percent.

2. Tulip Company is made up of two divisions: A and B. Division A produces a widget that Division B uses in the production of its product. Variable cost per widget is $1.35; full cost is $2.20. Comparable widgets sell on the open market for $2.90 each. Division A can produce up to 2.60 million widgets per year but is currently operating at only 50 percent capacity. Division B expects to use 130,000 widgets in the current year.

Required:
1. Determine the minimum and maximum transfer prices.
2. Calculate Tulip Company’s total benefit of having the widgets transferred between these divisions.
3. If the transfer price is set at $1.35 per unit, determine how much profit Division A will make on the transfer. Determine how much Division B will save by not purchasing the widgets on the open market.
4. If the transfer price is set at $2.90 per unit, determine how much profit Division A will make on the transfer. Determine how much Division B will save by not purchasing the widgets on the open market.
5. What transfer price would you recommend to split the difference?

Answer 1

ROI = Net operating income/Average invested assets

Residual income = Net operating income – Targeted income

                            = Net operating income – (Average invested assets x hurdle rate)

1.        

	River Division	Stream Division
Net operating income	$315,000	$528,000
÷ Average invested assets	$1,120,000	$1,520,000
ROI	28.13%	34.74%

	River Division	Stream Division
Net operating income	$ 315,000	$ 528,000
Average invested assets	$ 1,120,000	$ 1,520,000
x Hurdle rate	6.76 %	6.76 %
Targeted income	$ 75,712	$ 102,752
Residual income	$ 239,288	$ 425,248

2.

a.

Net operating income for River Division = $ 315,000 x 1.09 = $ 343,350

Net operating income for Stream Division = $ 528,000 x 1.09 = $ 575,520

	River Division	Stream Division
Net operating income	$ 343,350	$ 575,520
÷ Average invested assets	$ 1,120,000	$1,520,000
ROI	30.66%	37.86%

	River Division	Stream Division
Net operating income	$ 343,350	$ 575,520
Average invested assets	$ 1,120,000	$1,520,000
x Hurdle rate	6.76%	6.76%
Targeted income	$ 75,712	$ 1,02,752
Residual income	$ 267,638	$ 472,768

b.

Net operating income for River Division = $ 315,000 x 0.9 = $ 283,500

Net operating income for Stream Division = $ 528,000 x 0.9 = $ 475,200

	River Division	Stream Division
Net operating income	$ 283,500	$ 475,200
÷ Average invested assets	$ 1,120,000	$ 1,520,000
ROI	25.31%	31.26%

	River Division	Stream Division
Net operating income	$ 283,500	$ 475,200
Average invested assets	$ 1,120,000	$ 1,520,000
x Hurdle rate	6.76%	6.76%
Targeted income	$ 75,712	$ 1,02,752
Residual income	$ 207,788	$ 372,448

c.

For River Division:

Net operating income = $ 315,000 + $ 101,000 = $ 416,000

Average invested assets = $ 1,120,000 + $ 249,000 = $ 1,369,000

For Stream Division:

Net operating income = $ 528,000 + $ 101,000 = $ 629,000

Average invested assets = $ 1,520,000 + $ 249,000 = $ 1,769,000

	River Division	Stream Division
Net operating income	$ 416,000	$ 629,000
÷ Average invested assets	$ 1,369,000	$ 1,769,000
ROI	30.39%	35.56%

	River Division	Stream Division
Net operating income	$ 416,000	$ 629,000
Average invested assets	$ 1,369,000	$ 1,769,000
x Hurdle rate	6.76%	6.76%
Targeted income	$ 92,544	$ 119,584
Residual income	$ 323,456	$ 509,416

d.

	River Division	Stream Division
Net operating income	$ 315,000	$ 528,000
÷ Average invested assets	$ 1,120,000	$ 1,520,000
ROI	28.13%	34.74%

	River Division	Stream Division
Net operating income	$ 315,000	$ 528,000
Average invested assets	$ 1,120,000	$ 1,520,000
x Hurdle rate	4.76%	4.76%
Targeted income	$ 53,312	$ 72,352
Residual income	$ 261,688	$ 455,648