CHAPTER 13

Investment Centers and Transfer Pricing

EXERCISE 13-25 (15 MINUTES)

There are an infinite number of ways to improve the division's ROI to 25

percent. Here are two of them:

1. Improve the sales margin to 10 percent by increasing income to

$12,500,000:
ROI = sales margin  capital turnover
$12,500,000 $125,000,0
00

= $125,000,0
00 $50,000,000

= 10%  2.5 = 25%

Since sales revenue remains unchanged, this implies a cost reduction
of $2,500,000 at the same volume.

2. Improve the turnover to 3.125 by decreasing average invested capital to

$40,000,000:
ROI = sales margin  capital turnover
$10,000,000 $125,000,0
00

= $125,000,0
00 $40,000,000

= 8%  3.125 = 25%

Since sales revenue remains unchanged, this implies that the firm can
divest itself of some productive assets without affecting sales volume.

EXERCISE 13-26 (5 MINUTES)

Residual = investment center –  invested imputed 

income income   
 capital interest rate
= $10,000,000 – ($50,000,000 
11%)
= $4,500,000
EXERCISE 13-34 (10 MINUTES)

1. outlay opportuni
Transfer price = cost + ty
cost
= $450* + $120† = $570

*Outlay cost = unit variable production cost

†
Opportunity = forgone contribution margin
cost
= $570 – $450 = $120

2. If the Fabrication Division has excess capacity, there is no opportunity

cost associated with a transfer. Therefore:

outla opportunit
Transfer price = y + y
cost cost
= $450 + 0 = $450

EXERCISE 13-35 (25 MINUTES)

1. The Assembly Division's manager is likely to reject the special offer

because the Assembly Division's incremental cost on the special order
exceeds the division's incremental revenue:
Incremental revenue per unit in special order...... $1,000
Incremental cost to Assembly Division per unit
in special order:
Transfer price...................................................... $770
Additional variable cost..................................... 300
Total incremental cost............................................. 1,070
Loss per unit in special order................................ $ (70)
2. The Assembly Division manager's likely decision to reject the special
order is not in the best interests of the company as a whole, since the
company's incremental revenue on the special order exceeds the
company's incremental cost:
Incremental revenue per unit in special order. . . $1,000
Incremental cost to company per unit in special
order:
Unit variable cost incurred in Fabrication $590
Division..................................................................
Unit variable cost incurred in Assembly 300
Division..................................................................
Total unit variable cost......................................... 890
Profit per unit in special order............................. $ 110
3. The transfer price could be set in accordance with the general rule, as
follows:
outlay opportuni
Transfer = cost + ty
price cost
= $590 + 0*
= $590

*Opportunity cost is zero, since the Fabrication Division has excess

capacity.
Now the Assembly Division manager will have an incentive to accept
the special order since the Assembly Division's incremental revenue on
the special order exceeds the incremental cost. The incremental
revenue is still $1,000 per unit, but the incremental cost drops to $890
per unit ($590 transfer price + $300 variable cost incurred in the
Assembly Division).

PROBLEM 13-37 (45 MINUTES)

Division I Division II Division III

Sales revenue........................................... $2,000,000 $320,000e $1,600,000l
Income...................................................... $ 400,000 $ 80,000 $ 480,000k
Average investment................................. $1,000,000 $160,000f $2,000,000j
Sales margin............................................. 20%a 25% 30%
Capital turnover....................................... 2b 2 .8i
ROI............................................................. 40%c 50%g 24%
Residual income...................................... $ 300,000d $ 64,000 h
$ 280,000
Explanatory notes:
a income $400,000
Sales margin = = = 20%
sales revenue $2,000,000
b sales revenue $2,000,000
Capital turnover = = =2
invested capital $1,000,000

c
ROI = sales margin  capital turnover = 20%  2 = 40%
d
Residual income = income – (imputed interest rate)(invested
capital)
= $400,000 – (10%)($1,000,000) = $300,000
income
e
Sales = sales revenue
margin
$80,000
25% = sales revenue
Therefore, sales revenue = $320,000
 sales revenue
f
Capital = invested capital
turnover
$320,000
= invested capital

Therefore, invested capital = $160,000

g
ROI = sales margin  capital turnover
 
ROI = 25%  2 = 50%
h
Residual = income – (imputed interest rate)(invested capital)
income
= $80,000 – (10%)($160,000)
= $64,000
i
ROI = sales margin  capital turnover
24% = 30%  capital
turnover

Therefore, capital turnover = .8

income
j
ROI = invested capital = 24%
Therefore, income = (24%)(invested capital)
Residual = income – (imputed interest rate)(invested capital)
income
= $280,000
Substituting from above for income:
(24%)(invested capital) – (10%)(invested capital) =
$280,000
Therefore, (14%)(invested capital) = $280,000
So, invested capital = $2,000,000
income
k
ROI =
invested capital
income
24% = $2,000,000

Therefore, income = $480,000

l
income
Sales =
sales revenue
margin
 $480,000
30% = sales revenue
Therefore, sales revenue = $1,600,000

PROBLEM 13-40 (35 MINUTES)

1. Current ROI of the Western Division:

Sales revenue……………… $500,000
Less: Variable costs ($500,000 x $375,000
75%)
Fixed costs 100,000 475,000
Income…………………………………… $ 25,000
ROI = Income ÷ invested capital
= $25,000 ÷ $100,000
= 25%

Western Division’s ROI if competitor is acquired:

Sales revenue ($500,000 + $200,000) $700,000
Less: Variable costs [$375,000 +
($200,000 x 60%)] $495,000
………………..…………
Fixed costs ($100,000 + 170,000 665,000
$70,000)
Income…………………………………… $ 35,000

ROI = Income ÷ invested capital

= $35,000 ÷ [$100,000 + ($50,000
+ $30,000)]
= 19.40%

2. Divisional management will likely be against the acquisition

because ROI will be lowered from 25% to 19.40%. Since
bonuses are awarded on the basis of ROI, the acquisition will
result in less compensation.

3. An examination of the competitor’s financial statistics

reveals the following:

Sales $200,000
revenue…………………………………
Less: Variable costs ($200,000 x $120,000
60%)
Fixed costs 70,000 190,000
Income…………………………………… $ 10,000
ROI = Income ÷ invested capital
= $10,000 ÷ $50,000
 = 20%
Corporate management would probably favor the
acquisition. Megatronics has been earning a 13% return, and
the competitor’s ROI of 20% will help the organization as a
whole. Even if the $30,000 upgrade is made, the competitor’s
ROI would be 15% if past earnings trends continue [$10,000 ÷
($50,000 + $30,000) = 12.5%].

4. Yes, the divisional ROI would increase to 23.30%. However,

the absence of the upgrade could lead to long-run problems,
with customers being confused (and perhaps turned-off) by
two different retail environments—the retail environment
they have come to expect with other Megatronics outlets and
that of the newly acquired, non-upgraded competitor.

Sales revenue ($500,000 + $200,000) $700,000

Less: Variable costs [$375,000 +
($200,000 x 60%)] $495,000
…………………………
Fixed costs ($100,000 + 170,000 665,000
$70,000).........
Income…………………………………… $ 35,000
ROI = Income ÷ invested capital
= $35,000 ÷ ($100,000 + $50,000)
= 23.30%

5. Current residual income of the Western Division:

Divisional profit………………………… $25,000
Less: Imputed interest charge ($100,000 x 15%) 15,000
Residual income……………………… $10,000

Residual income if competitor is acquired:

Divisional profit ($25,000 + $10,000) $35,000
……………........
Less: Imputed interest charge [($100,000 +
($50,000 + $30,000)) x 10%] 18,000
Residual income………………… $17,000

Yes, management most likely will change its attitude.

Residual income will increase by $7,000 ($17,000 - $10,000)
as a result of the acquisition.