Question

Oxford Company has two divisions. Thames Division, which has an investment base of $80,500,000, produces and sells 920,000 units of a product at a market price of $144 per unit. Its variable costs total $40 per unit. The division also charges each unit $70 of fixed costs based on a capacity of 1,000,000 units.

Lakes Division wants to purchase 230,000 units from Thames. However, it is willing to pay only $80 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?

b. What is Thames’s residual income if it transfers 230,000 units to Lakes at $80 each?

c. What is the minimum transfer price for the 230,000-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.)

Answer 1

a) Residual Income = Operating Income - (Operating Assets*Cost of capital)

Operating Income = [(Contribution Margin*Units sold) - Fixed Costs]

= [$144-$40)*920,000] - (1,000,000*$70)

= $95,680,000 - $70,000,000 = $25,680,000

Operating Assets = $80,500,000

Residual Income = $25,680,000 - ($80,500,000*12%)

= $25,680,000 - $9,660,000 = $16,020,000

b) If thames transfers 230,000 units to Lakes then regular sales will be reduced to 770,000 units (1,000,000 units - 230,000 units) because the maximum production capacity is 1,000,000 units.

New Operating Income = [$144-$40)*770,000] +[$80-$40)*230,000] - (1,000,000*$70)

= $80,080,000+$9,200,000-70,000,000 = $19,280,000

Residual Income = $19,280,000 - ($80,500,000*12%)

= $19,680,000 - $9,660,000 = $10,020,000

c) Desired Operating Income = $25,680,000

Total Desired Contribution Margin = $25,680,000+$70,000,000 = $95,680,000

Contribution margin from regular sales of 770,000 units = $80,080,000

Required Contribution margin from special order = $95,680,000-$80,080,000

= $15,600,000

Contribution margin per unit = $15,600,000/230,000 units = $67.83 per unit

Minimum transfer price = Required Contribution Margin+Variable costs

= $67.83+$40 = $107.83

The minimum transfer price for the 230,000-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 is $107.83 per unit.