Question

Tiny went back to his office after the meeting and began to crunch the numbers on the rapid inflator. At a price of $10 per unit, the marketing department estimates demand for the product at 40,000 units. The division will need to purchase a new machine for $100,000 to produce the inflator. Mary estimates that the division will incur an additional $140,000 in fixed costs that are directly attributable to the inflator.
One component of the inflator is currently produced by Holiday's Lighting Division at a variable cost of $3 per unit. The component is sold to outside customers (other manufacturers) for $5 per unit. Tiny met with Sammy Shine, vice president of the Lighting Division, earlier in the week to discuss the possibility of the Lighting division supplying the component to the Inflatables Division. "Sure," Sammy began, "I'd like to help you out on this. We can provide the components at our market price of $5 per unit. We have the capacity to make 150,000 of the components, and we're currently making only 135,000 for our external customers." Tiny thanked Sammy for his time saying, "I'll get back to you next week,"

The Inflatables Division currently earns $250,000 on $2.5 million in sales revenue. The division has an asset base of $1,250,000. Tiny knows that Winter will not be happy if the new product reduces the division's return on investment and he is concerned that Sammy's offer to sell the component at $5 per unit will push product costs too high tot maintain the division's ROI. He thinks that if he can meet with Sammy again to explain the situation, maybe he can negotiate a lower transfer price.

Required:
1. What is the Inflatable Division's current return on investment?
2. Given the projected demand for the inflator and current cost estimates for the product, what is the maximum total variable cost that Tiny can incur and still maintain the division's ROI? What would be the resulting contribution margin per unit for the inflator?
3. What is the minimum transfer price that the Lighting division should be willing to charge the Inflatable division for the 40,000 components it needs to produce the inflator?
4. Regardless of your answer to question 2, assume Tiny has determined that the maximum acceptable variable cost per unit is $6 and that all but $2 of that cost will be attributable to the component transferred from the Lighting division. Will Tiny accept the Lighting division's minimum transfer price? Why or why not?
5. Suppose that Winter has decided to evaluate divisional vice president's based on residual income rather than return on investment. If she requires a 14% minimum rate of return, will Tiny be able to accept the Lighting division's minimum transfer price? Why or why not?
6. What do you recommend?

Answer 1

Solution and Explanation:

Part A -   Inflatable divisions's Current Return on Investment = Yearly Earnings / Investment Cost * 100

There the Inflatable Division is Currently Earning $ 250,000 annually from an Asset base of $ 1,250,000

Therefore, ROI = $250000 / 1250000 * 100=20 \%$

Part B -   Let the maximum variable cost be X.

Given that - 1. Selling Price per Unit = $10 , 2. No of Units to be produced = 40000 , 3. Annual Fixed Cost = $ 140000

Therefore ,   ROI = Current Earning + New Earning / Current Assets + New Assets

20% = $250000+[(10-\mathrm{X}) * 40000-\underline{140000}] / 1250000+100000$

Solve for X getting, X = 6

Therefore maximum variable cost it can incur without change in current ROI is $ 6 per unit  

Resulting Contribution Margin per Unit = SP - VC = $10 minus $6 = $4 per unit

part C -   Minimum Transfer Lightning division Should charge

Given Information - Capacity of Lightning division is 150000 units and Utilized capacity is 135000 units. Therefore Spare capacity is 15000 units .Also Market Price of Product of Lightning division is $ 5 and Variable cost is $3 per unit.

So for the First 15000 units of Requirement of Inflatable division - Transfer Price should be Variable cost i.e $ 3 per unit because Lightning division has spare capacity in this.

For the next 25000 units of requirement of Inflatable division - Transfer Price should be Market Price i.e $ 5 per unit as Lightning division has to reduce is external sale.

Therefore Minimum TP = 1$5000 * 3+25000 * 5 / 40000=\ 4.25$ per Unit

Part D -  No, Here Tiny offers to transfer $4 ( $6 - $2 ) per unit to Lightning division. However  the minimum TP Lightning should get is 4.25 per unit and if less than this TP is offered by Tiny it will lead to loss in the Lightning Division.