Corporate Tax Rate

40%

20%

It should be noted that the demand and unit sales of RR7 include the demand from, and sales to, the Blue division. The Red division is selling 100,000 units to the Blue division and 100,000 units to external customers. Additionally, the Blue division has total external demand of 150,000 units of BB9, but since the Red division is only willing to sell it 100,000 units of RR7 it only makes and sells 100,000 units of BB9. Because of logistical issues, the Blue division has decided not to go to the external market to purchase additional units RR7.

Each divisional manager receives a bonus of $6,750 for each percentage point of after-tax ROI (i.e., return on investment = after-tax profit / investment) that they generate. B’s manager blames the low ROI in division B on two factors: (1) the high transfer price of product RR7 and (2) the fact that the R division will only transfer 100,000 units even though the B division wants to purchase 150,000 units. Regarding the transfer price of RR7, R division currently charges B the outside price of $50. The manager of R claims that this is appropriate since this is the price ‘determined by market forces’. The manager of B argues that intra-group transfers should be charged at a lower price based on the costs of the producing division plus a ‘reasonable’ mark-up. Regarding the number of units transferred, the R division manager argues that to transfer any additional units would require cutting off sales to current customers.


Questions:


a.

Calculate the current bonus paid to each divisional manager.


b.

Assume that the tax authorities in both countries allow firms to choose whatever transfer price they wish provided that both the selling and buying division generate a minimum contribution margin of zero from the transaction. Assuming no change to the corporate overhead allocation charge, what is the optimal transfer pricing policy and transfer for the firm as a whole? Based on your suggestion, what bonus will be paid to each divisional manager?



Exercise 5

Brasswill Manufacturing produces a number of different products for both commercial and individual customers. Given the large number of different products produced and sold, Brasswill is divided into multiple divisions.

Janet James, the manager of the Appliance Division is contemplating adding a new product line (a commercial dishwasher). Currently her division produces and sells a commercial refrigeration unit. For the upcoming fiscal year, Janet expects that she will produce and sell 8,500 refrigeration units at a price of $2,500 per unit. The expected manufacturing costs per refrigeration unit are as follows:

– Direct Material           $800/unit

– Direct Labor            $425/unit

– Variable Overhead           $365/unit

– Fixed Overhead           $290/unit

In addition, it is expected that each unit sold will incur a shipping cost of $175/unit. Finally, Janet is expecting to incur $1,245,500 in fixed non-manufacturing costs. Currently, there is $19,000,000 invested in the Appliance Division, and the division has a cost of capital of 11%.

Regarding the new product (the commercial dishwasher), Janet has estimated the following financial information:

– Unit Sales                4,000

– Sales Price                     ???

– Direct Material           $330/unit

– Direct Labor            $175/unit

– Variable Overhead           $110/unit

– Shipping Cost           $125/unit

– Fixed Marketing           $310,000

To produce the commercial dishwasher, Janet will need to purchase new equipment which is expected to cost $4,000,000 with a useful life of 16 years and no salvage value. Brasswill uses straight-line depreciation.

Janet, as are all managers at Brasswill, is evaluated and compensated on her division’s residual income.


Questions:


a.

What is Janet’s expected residual income before adding the new product?


b.

What is the minimum price that Janet will likely be willing to charge for the new commercial dishwasher?