Question

Oxford Company has two divisions. Thames Division, which has an investment base of $80,100,000, produces and sells 920,000 units of a product at a market price of $146 per unit. Its variable costs total $42 per unit. The division also charges each unit $70 of fixed costs based on a capacity of 1,100,000 units.

Lakes Division wants to purchase 250,000 units from Thames. However, it is willing to pay only $81 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 250,000 units to Lakes at $81 each?

	Residual income

c. What is the minimum transfer price for the 250,000-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 920,000 units to the outside market? (Round your answer to 2 decimal places.)

	Minimum transfer price per unit

Answer 1

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

[Units sold * (SP – VC)] – Fixed cost – (Investment * cost of capital)

[920000 * ($146 - $42)] – (1100000 * $70) – ($80100000 * 12%)

$95680000 - $77000000 - $9612000 = $9068000

b. What is Thames’s residual income if it transfers 250,000 units to Lakes at $81 each?

Capacity = 1100000

Transfer = 250000

Sale to outside market = 850000

[Units sold * (SP – VC)] + [Units transfer * (TP – VC)]– Fixed cost – (Investment * cost of capital)

[850000 * ($146 - $42)] + [250000 * ($81 - $42)] – (1100000 * $70) – ($80100000 * 12%)

= $88400000 + $9750000 - $77000000 - $9612000 = $11538000

c. What is the minimum transfer price for the 250,000-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 920,000 units to the outside market? (Round your answer to 2 decimal places.)

[Units sold * (SP – VC)] + [Units transfer * (TP – VC)]– Fixed cost – (Investment * cost of capital) = $9068000

[850000 * ($146 - $42)] + [250000 * (TP - $42)] – (1100000 * $70) – ($80100000 * 12%) = $9068000

$88400000 + (250000 * TP) - $10500000 - $77000000 - $9612000 = $9068000

TP = $71.12