Deck 5: Responsibility Accounting and Transfer Pricing

Question 1

Celtex
Celtex is a large and very successful decentralized specialty chemical producer organized into five independent investment centers. Each of the five investment centers is free to buy products either inside or outside the firm and is judged based on residual income. Most of each division's sales are to external customers. Celtex has the general reputation of being one of the top two or three companies in each of its markets.
Don Horigan, president of the synthetic chemicals (Synchem) division, and Paul Juris, president of the consumer products division, are embroiled in a dispute. It all began two years ago when Juris asked Horigan to modify a synthetic chemical for a new household cleaner. In return, Synchem would be reimbursed for out-of-pocket costs. After Synchem spent considerable time perfecting the chemical, Juris solicited competitive bids from Horigan and some outside firms and awarded the contract to an outside firm that was the low bidder. This angered Horigan, who expected his bid to receive special consideration because he developed the new chemical at cost and the outside vendors took advantage of his R D.
The current conflict involves Synchem's production of chemical Q47, a standard product, for consumer products. Because of an economic slowdown, all synthetic chemical producers have excess capacity. Synchem was asked to bid on supplying Q47 for the consumer products division. Consumer products is moving into a new, experimental product line, and Q47 is one of the key ingredients. While the order is small relative to Synchem's total business, the price of Q47 is very important in determining the profitability of the experimental line. Horigan bid $3.20 per gallon. Meas Chemicals, an outside firm, bid $3.00. Juris is angry because he knows that Horigan's bid contains a substantial amount of fixed overhead and profit. Synchem buys the base raw material, Q4, from the organic chemicals division of Celtex for $1.00 per gallon. The organic chemical division's out-ofpocket costs (i.e., variable costs) are 80 percent of the selling price. Synchem then further processes Q4 into Q47 and incurs additional variable costs of $1.75 per gallon. Synchem's fixed manufacturing overhead adds another $0.30 per gallon. Horigan argues that he has $3.05 of cost in each gallon of Q47. If he turned around and sold the product for anything less than $3.20, he would be undermining his recent attempts to get his salespeople to stop cutting their bids and start quoting full-cost prices.
Horigan has been trying to enhance the quality of the business he is getting, and he fears that if he is forced to make Q47 for consumer products, all of his effort the last few months will be for naught. He argues that he already gave away the store once to consumer products and he won't do it again. He asks, "How can senior managers expect me to return a positive residual income if I am forced to put in bids that don't recover full cost?" Juris, in a chance meeting at the airport with Debra Donak, senior vice president of Celtex, described the situation and asked Donak to intervene.
Juris believed Horigan was trying to get even after their earlier clash. Juris argued that the success of his new product venture depended on being able to secure a stable, high-quality supply of Q47 at low cost.
Required:
a. Calculate the incremental cash flows to Celtex if the consumer products division obtains Q47 from Synchem versus Meas Chemicals.
b. What advice would you give Debra Donak?

Answer 1

Transfer Price
Transfer price is the price which is charged by the internal department of an entity from one another. This price is generally less than the market price. Sometimes prices charged between two related parties are also termed as transfer price. Setting a transfer price is always difficult as it involves a contradiction in the two departments of an entity.
Opportunity Cost
It is the income foregone which could have earned if the current task has not opted. Since an opportunity of income is forgiven it is termed as opportunity cost. A famous person once said, "no coming of money is equivalent to going of money".
This refers to that the income you have forgiven is now a cost which should be recovered from the adopted task. If it is not recovered then there is ultimately loss of the amount not recovered.a
Calculate the excess cash flow of the product is purchased from M using MS Excel as follows:
The result of above is as follows:
Hence if the company purchases from m instead of S then it will have to spend extra $0.45 for every gallon. It is to be noted that the opportunity cost of the plant is 0 and fixed overheads cannot be eliminated.b.In the present case, the S department wants to charge some profit and fixed overheads from the experimental department of C but this cost is more than the market cost of $3. If the experimental department buys from outside then he needs to pay $0.45 extra because the fixed overheads will continue to incur.
The company follows decentralization and therefore decisions regarding the transfer price are made by the manger. Since purchasing from outside costs more it is obvious that the purchase from S department is beneficial for the company. But to execute the transfer price should be such which is not more than the market price of the product.
It is advised that the corporate manager should not intervene in between because it will harm the very basic purpose of the decentralization instead the corporate manager should remove the S department's manager if his actions are not beneficial to the company as a whole.

Question 2

Canadian Subsidiary
The following data summarize the operating performance of your company's wholly owned Canadian subsidiary for 2009 to 2011. The cost of capital for this subsidiary is 10 percent.

Required:
Critically evaluate the performance of this subsidiary.

Answer 2

Net Income:
The resultant amount after reducing all expenses of the company weather direct or indirect for the period from all revenues is termed as net income.Cost of Capital:
It refers to the margin of profit which is lost on a particular source of investment by the entity i.e. the amount of income that the entity might have earned on the same amount of investment if that particular investment was being invested in some better source of investment. The factor of risk in both the investment sources will be same.Subsidiary Company
A subsidiary company is a company in which the major shareholding is held by some other company which is called the parent company. There may be one parent company or may even be multiple parent company. Such parent company is involved in major management decisions of it subsidiary.
In the present case, C Company is the wholly owned subsidiary of Y Company and C Company earned net income of $14,000,000 in 2009, $14,300,000 in 2010 and $14,400,000 in 2011 and return on investment in subsidiary for three years are 20%, 22%, and 24% respectively.
Prepare a schedule to compute the net investment and residual income of C Company using MS Excel, which will be shown as follows:
The result of above will be as follows:
The net investment of subsidiary company is reduced from $70 million to $60 million and it also makes a change in its capital structure by increasing debt funds and reducing equity funds.
The net income of subsidiary also have an increasing trend and due to a decrease in net investments of the company the return on investment get improved but this improvisation does not have any effect of operating performance of the company.

Question 3

Executive Inn
Sarah Adams manages Executive Inn of Toronto, a 200-room facility that rents furnished suites to executives by the month. The market is for people relocating to Toronto and waiting for permanent housing. Adams's compensation contains a fixed component and a bonus based on the net cash flows from operations. She seeks to maximize her compensation. Adams likes her job and has learned a lot, but she expects to be working for a financial institution within five years. Adams's occupancy rate is running at 98 percent, and she is considering a $10 million expansion of the present building to add more rental units. She has very good private knowledge of the future cash flows. In year 1, they will be $2 million and will decline $100,000 a year. The following table summarizes the expansion's cash flows:

Based on the preceding data, Adams prepares a discounted cash flow analysis of the addition, which is contained in the following report:

The discount factors are based on a weighted-average cost of capital of 12 percent, which accurately reflects the inn's nondiversifiable risk.
Adams's boss, Kathy Judson, manages the Inn Division of Comfort Inc., which has 15 properties
located around North America, including Executive Inn of Toronto. Judson does not have the detailed knowledge of the Toronto hotel/rental market as Adams does. Her general knowledge is not as detailed or as accurate as Adams's. (For the following questions, ignore taxes.)
Required:
a. The Inn Division of Comfort Inc. has a very crude accounting system that does not assign the depreciation of particular inns to individual managers. As a result, Adams's annual net cash flow statement is based on the operating revenues less operating expenses. Neither the cost of expansion nor depreciation on expanding her inn is charged to her operating statement. Given the facts provided so far, what decision do you expect her to make regarding building the $10 million addition? Explain why.
b. Adams prepares the following report for Judson to justify the expansion project:

Judson realizes that Adams's projected cash flows are most likely optimistic, but she does not know how optimistic or even whether or not the project is a positive net present value project. She decides to change Adams's performance measure used in computing her bonus. Adams's compensation will be based on residual income (EVA). Judson also changes the accounting system to track asset expansion and depreciation on the expansion. Adams's profits from operations will now be charged for straight-line depreciation of the expansion using a 10-year life (assume a zero salvage value). Calculate Adams's expected
residual income from the expansion for each of the next 10 years.
c. Based on your calculations in part ( b ), will Adams propose the expansion project? Explain why.
d. Instead of using residual income as Adams's performance measure in part ( b ), Judson uses net cash flows from operations less straight-line depreciation. Will Adams seek to undertake the expansion? Explain why.
e. Reconcile any differences in your answers for parts ( c ) and ( d ).

Answer 3

Residual income
Residual income is another method used to determine performance of division. It subtracts the opportunity cost of capital employed from divisional performance. Residual income is therefore excess of earnings earned over the cost of capital.
Formula to calculate residual income
a.In given case A would propose the addition of building $10 million because net cash flow for years 1-10 is positive with expansion and A would not be charged for expansion of building. This expansion would increase her compensation.
b.Use the below formula to calculate residual income
The cost of capital used would be 12% and A would be using expected cash flow calculated by her rather than cash flow estimate used by her to justify the project as she would not want biased estimate of the project on her decision to accept project.
Calculate residual income for each year as shown below
Following shows the working
c.Based on residual value A would not propose expansion. This is because the residual value is negative and lower which would reduce her compensation amount.
d.If A's compensation is dependent on operating profit after depreciation then she would accept the project expansion as operating profit after depreciation for each year is positive.e.The difference in part (c) and (d) is that in part (c) 12% cost of capital is considered for which A needs to pay while in (d) A need not pay for the cost of capital and thus operating profit after depreciation for each year is positive.

Question 4

Phipps Electronics
Phipps manufactures circuit boards in Division Low in a country with a 30 percent income tax rate and transfers them to Division High in a country with a 40 percent income tax. An import duty of 15 percent of the transfer price is paid on all imported products. The import duty is not deductible in computing taxable income. The circuit boards' full cost is $1,000 and variable cost is $700; they are sold by Division High for $1,200. The tax authorities in both countries allow firms to use either variable cost or full cost as the transfer price.
Required: Analyze the effect of full-cost and variable-cost transfer pricing methods on Phipps' cash flows.

Question 5

Royal Resort and Casino
Royal Resort and Casino (RRC), a publicly traded company, caters to affluent customers seeking plush surroundings, high-quality food and entertainment, and all the "glitz" associated with the best resorts and casinos. RRC consists of three divisions: hotel, gaming, and entertainment. The hotel division manages the reservation system and lodging operations. Gaming consists of operations, security, and junkets. Junkets offers complimentary air fare and lodging and entertainment at RRC for customers known to wager large sums. The entertainment division consists of restaurants, lounges, catering, and shows. It books lounge shows and top-name entertainment in the theater. Although many of those people attending the shows and eating in the restaurants stay at RRC, customers staying at other hotels and casinos in the area also frequent RRC's shows, restaurants, and gaming operations. The following table disaggregates RRC's total EVA of $12 million into an EVA for each division:

Based on an analysis of similar companies, it is determined that each division has the same weighted-average cost of capital of 15 percent. Across town from RRC is a city block with three separate businesses: Big Horseshoe Slots Casino, Nell's Lounge and Grill, and Sunnyside Motel. These businesses serve a less affluent clientele.
Required:
a. Why does RRC operate as a single firm, whereas Big Horseshoe Slots, Nell's Lounge and Grill, and Sunnyside Motel operate as three separate firms?
b. Describe some of the interdependencies that are likely to exist across RRC's three divisions.
c. Describe some of the internal administrative devices, accounting-based measures, and/or organizational structures that senior managers at RRC can use to control the interdependencies that you described in part (b).
d. Critically evaluate each of the "solutions" you proposed in part (c).

Question 6

Sunder Properties
Brighton Holdings owns private companies and hires professional managers to run its companies. One company in Brighton Holdings' portfolio is Sunder Properties. Sunder owns and operates apartment complexes, and has the following operating statement.

Brighton Holdings estimates Sunder Properties' before-tax weighted average cost of capital to be 15 percent. Brighton Holdings rewards managers of their operating companies based on the operating company's before-tax return on assets. (The higher the operating company's before-tax ROA, the more Sunder managers are paid.) Sunder Properties' total assets at the end of the last fiscal year are $64 million.
Required:
a. Calculate Sunder's ROA last year.
b. Sunder management is considering purchasing a new apartment complex called Valley View that has the following operating characteristics (millions $):

Will the managers of Sunder Properties purchase Valley View?
c. If they had the same information about Valley View as Sunder's management, would the shareholders of Brighton Holdings accept or reject the acquisition of Valley View in part (b)?
d. What advice would you offer the management team of Brighton Holdings?

Question 7

Economic Earnings
A large consulting firm is looking to expand the services currently offered its clients. The firm has developed a new performance metric called "Economic Earnings," or EE for short. The performance metric is argued to be a better measure of both divisional performance and firmwide performance, and hence "a more rational platform for compensating employees and managers." The consulting firm is seeking to convince clients they should replace their current metrics, such as accounting net income, ROA, EVA, and so forth, with EE.
EE starts with traditional accounting net income but then makes a series of adjustments. The primary adjustment is to add back depreciation and then subtract a required return on invested capital. The consultants argue for adding accounting depreciation back because it is a sunk cost. It does not represent a current cash flow. For example, suppose a client has accounting net income calculated as:

Suppose the client has total assets of $6,000 and a risk-adjusted weighted-average cost of capital (WACC) of 25 percent. Then this client's EE is calculated as follows:

Required:
Critically evaluate EE as a performance measure. What are its strengths and weaknesses?

Question 8

Performance Technologies
Sylvia Zang is president of the Wilson Division of Performance Technologies, a multinational conglomerate. Zang manages $100 million of assets and is currently generating earnings before interest (EBI) of $12 million. The corporate office of Performance Technologies has determined that Wilson's existing assets have a risk-adjusted cost of capital of 11 percent. All division presidents (including Zang) are rewarded based on their individual division's ROA. If Zang is able to increase the Wilson Division's current ROA, she can earn a substantial bonus whereby the larger the increase in the division's ROA, the larger is Zang's bonus. Performance Technology computes ROA as EBI divided by total assets.
Currently, Zang is considering two new investment opportunities: Project A and Project B. She can accept one or the other, or both, or neither. Each project, A and B, has a risk profile that differs from that of her existing portfolio of assets. Project A (with a risk-adjusted cost of capital of 15 percent) requires her purchasing new assets for $25 million that will generate EBI of $3.5 million. Project B (with a risk-adjusted cost of capital of 9 percent) requires her purchasing new assets for $30 million that will generate EBI of $3 million.
Assume there are no synergies between Wilson's existing assets and either project A and B, and there are no synergies between project A and project B.
Required:
a. Assuming that Zang is rewarded based on improving the ROA of the Wilson Division, will she accept or reject projects A and B? Support your answer with detailed computations.
b. Instead of basing divisional managers' bonuses on ROA, Performance Technologies switches to residual income as the methodology used to measure divisional performance and reward divisional managers, including Ms. Zang. Assuming that Zang is rewarded based on improving the residual income of the Wilson Division, what decision(s) will she make regarding accepting or rejecting projects A and B? Support your answer with detailed computations.
c. Discuss why your answers differ or are the same in parts (a) and (b).
d. Should Performance Technologies use ROA or residual income to evaluate and reward division managers? Justify your recommendation with sound logical analysis.

Question 9

Metal Press
Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the historical cost of the asset is updated, a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19 percent to this cost, representing the change in the wholesale price index over the seven years. This new, higher cost figure is depreciated using the straight-line method over the same 12-year assumed life (no salvage value).
Required:
a. Calculate depreciation expense and book value of the metal press under both historical cost and price-level-adjusted historical cost.
b. In general, what is the effect on ROA of changing valuation bases from historical cost to current values?
c. The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the manager's incentives to replace the metal press change if the firm shifts from historical cost valuation to the proposed price-level-adjusted historical cost valuation?

Question 10

ICB, Intl.
ICB has four manufacturing divisions, each producing a particular type of cosmetic or beauty aid. These products are then transferred to five marketing divisions, each covering a particular geographic region. Manufacturing and marketing divisions are free to negotiate among themselves the transfer prices for products transferred internally. The manufacturing division that produces all the hair care products wants a particular hair conditioner it developed and produces for Asian markets priced at full cost plus a 5 percent profit markup, which amounts to $105 per case. The South American marketing division believes it can sell this conditioner in South America after redesigning the labels. However, most South American currencies have weakened the dollar, putting further pressure on the prices of U.S.-produced products. The South American marketing division estimates it can make money on the hair conditioner only if it can buy it from manufacturing at $85 per case.
Manufacturing claims that it cannot make a profit at $85 per case. Moreover, the other ICB marketing divisions that are paying around $105 per case will likely want to renegotiate the $105 transfer price if South America marketing buys it for $85.
You work for the corporate controller of ICB, Intl. She has asked you to write a short, nontechnical memo to her that spells out the key points she should consider in her upcoming meeting with the two division heads regarding transfer pricing. You are not being asked to recommend a particular transfer price, but rather to list the important issues the controller should be aware of for the meeting.

Question 11

Shop and Save
Shop and Save (S S) is a large grocery chain with 350 supermarkets. Twenty-eight S S stores are located within the Detroit metropolitan region and serviced by the S S Detroit Bakery, a large central bakery producing all of the fresh-baked goods (breads, rolls, donuts, cakes, and pies) sold in the 28 individual S S stores in the Detroit region. Besides selling S S baked goods, the stores also sell other nationally branded commercial baked goods both in the baked goods section of the store and in the frozen section as well. But all freshly baked items sold in the 28 S S stores come from the S S Detroit Bakery. Each store orders all the baked goods from the S S Detroit Bakery the day before. The S S Detroit Bakery also is a profit center and sells only to the 28 Detroit S S stores. Each store pays the bakery 60 percent of the retail selling price. So, for example, if a store manager orders from the bakery a loaf of whole grain bread that has a retail price of $5.00, that store is charged $3.00 (60% × $5.00) and the Detroit Bakery records revenues of $3.00.
Each store manager is evaluated and compensated as a profit center and has some decision rights over the particular items stocked in each store. But roughly 85 percent of all SKUs (stock keeping units) carried by each store and the retail price of each SKU are dictated centrally by the S S Detroit Regional headquarters, which oversees both the 28 stores and the bakery. Each store manager has decision rights over the quantity of the various baked goods ordered from the S S Detroit Bakery. The retail price of each freshly baked item produced by the S S Detroit Bakery and sold in the grocery stores is set by the Detroit Regional headquarters, not the individual grocery stores or the S S Detroit Bakery.
The manager of the Detroit Bakery complains that the reason her central bakery loses money is that the 60 percent rate is too low to cover her costs. The individual grocery store managers complain that the quality and variety of fresh baked goods they receive from the S S Detroit Bakery are not competitive with high-end private specialty bake shops in the Detroit area.
Required:
a. Evaluate the advantages and disadvantages of the S S policy of each S S grocery store paying the S S Detroit Bakery 60 percent of the retail price of the bakery item.
b. Suggest ways that S S can improve the relationship between its grocery stores and its central bakery.

Question 12

Microelectronics
Microelectronics is a large electronics firm with multiple divisions. The circuit board division manufactures circuit boards, which it sells externally and internally. The phone division assembles cellular phones and sells them to external customers. Both divisions are evaluated as profit centers. The firm has the policy of transferring all internal products at market prices. The selling price of cellular phones is $400, and the external market price for the cellular phone circuit board is $200. The outlay cost for the phone division to complete a phone (not including the cost of the circuit board) is $250. The variable cost of the circuit board is $130.
Required:
a. Will the phone division purchase the circuit boards from the circuit board division? (Show calculations.)
b. Suppose the circuit board division is currently manufacturing and selling externally
10,000 circuit boards per month and has the capacity to manufacture 15,000 boards. From
the standpoint of Microelectronics, should 3,000 additional boards be manufactured and transferred internally?
c. Discuss what transfer price should be set for part (b).
d. List the three most important assumptions underlying your analysis in parts (b) and (c).

Question 13

US Copiers
US Copiers manufactures a full line of copiers including desktop models. The Small Copier Division (SCD) manufactures desktop copiers and sells them in the United States. A typical model has a retail price of less than $500. An integral part in the copier is the toner cartridge that contains the black powder used to create the image on the paper. The toner cartridge can be used for about 10,000 pages and must then be replaced. The typical owner of an SCD copier purchases four replacement cartridges over the life of the copier.
SCD buys the initial toner cartridges provided with the copier from the Toner Division (TD) of US Copiers. TD sells subsequent replacement cartridges to distributors that sell them to U.S. retail stores. Toner cartridges sell to the end consumer for $50. TD sells the cartridges to distributors for about 70 percent of the final retail price paid by the consumer. The Toner Division manager argues that the market price to TD of $35 (70% × $50) is the price SCD should pay to TD for each toner cartridge transferred.
Required:
a. Why does US Copiers manufacture both copiers and toner cartridges? Why don't separate firms specialize in either copiers or toner cartridges like Intel specializes in making computer chips and Gateway specializes in assembling and selling PCs?
b. You work for the president of SCD. Write a memo to your boss identifying the salient issues she should raise in discussing the price SCD should pay TD for toner cartridges included in SCD copiers.

Question 14

Cogen
Cogen Cogen's Turbine Division manufactures gas-powered turbines for generating electric power and hot water for heating systems. Turbine's variable cost per unit is $150,000 and its fixed cost is $1.8 million per month. It has excess capacity. Cogen's Generator Division buys gas turbines from Cogen's Turbine Division and incorporates them into electric steam-generating units. Both divisional managers are evaluated and rewarded as profit centers.
The Generator Division has variable cost of $200,000 per completed unit, excluding the cost of the turbine, and fixed cost of $1.4 million per month. The Generator Division faces the following monthly demand schedule for its complete generating unit (turbine and generator):

Required:
a. If the transfer price of turbines is set at Turbine's variable cost ($150,000), how many turbines will the Generator Division purchase to maximize its profits?
b. The Turbine Division expects to sell a total of 20 turbines a month, which includes both external and
c. If the transfer price of turbines is set at Turbine's (average) full cost calculated in part (b), how many turbines will the Generator Division purchase?
d. Should Cogen use a variable-cost transfer price or a full-cost transfer price to transfer turbines between the Turbine and Generator divisions? Why?

Question 15

Wegmans
Wegmans, a privately owned regional supermarket chain founded in Rochester, New York, in 1916, focuses on the more affluent market by providing a unique shopping experience and value. Wegmans' much larger stores stock roughly twice as many items as other supermarkets and offer more displays of fresh produce, artisan breads, fresh seafood, and take-out or in-store dining of restaurant-quality entrees. The company currently operates more than 80 stores and 10 regional distribution centers in five states stretching from New York to Virginia. Their most recent expansion is into Virginia with three new stores and a new Wegmans Virginia distribution center serving the three new stores, but with capacity to serve more Virginia stores as they are opened.
As Wegmans expands geographically, it must open regional distribution centers that are responsible for accurate and on-time selection, inventorying, and delivery of the thousands of products (fresh produce, meats, seafood, frozen goods, etc.) sold in the stores in that distribution center's region. Each store in the region is allocated a share of the costs of its distribution center based on total store revenues served by the distribution center.
Senior management uses residual income to evaluate the performance of each store (and reward store management). All Wegmans stores face the same weighted-average cost of capital (13 percent) applied to direct investment in each store (working capital and property, building, and fixtures). The following table summarizes last year's operations of the newest Virginia store (Virginia 3), Wegmans flagship store (Rochester 1), and the Wegmans store with median revenues across the entire 80-store chain (Median). Virginia 3's results in the table represent the first complete year of operations since opening the store. "Rochester 1" is Wegmans' first megastore, rebuilt and expanded in 1990, with a very large and loyal customer base. All figures are in thousands of dollars.

Required:
a. Compute the residual incomes for the Virginia 3, Rochester 1, and the Median stores.
b. Write a memo to senior Wegmans management evaluating the performance of Virginia 3 relative to Rochester 1 and to the Median store. Be sure to provide credible explanations for all material differences in performance between Virginia 3 and the other two Wegmans stores.

Question 16

Zee Spin Wedges
Zee Spin manufactures a line of golf club wedges (sand wedge, pitching wedge, lob wedge, and attack wedge) that vary with loft and club head sole design. The wedges have become very popular among professional and serious golfers because of their unique club head design and shafts. All Zee Spin wedges consist of three parts: club head, shaft, and grip. Zee Spin manufactures the club heads and shafts and purchases the grips. The three components are assembled to produce a wedge that is sold to distributors, who then sell them to golf pro shops and websites. The shafts are specially designed to match the playing characteristics of the Zee Spin wedge club head.
The following table summarizes the total costs of producing a complete Zee Spin wedge. All the various models of Zee Spin wedges (sand wedge, pitching wedge, lob wedge, and attack wedge) have the same cost structure.

Zee Spin traditionally only sold complete wedges (club head, shaft, and grip), and the company Was treated as a single profit center. But with the success of the Zee Spin brand and recent inquiries from other club makers about purchasing just Zee Spin shafts, which are unique in the industry, Zee Spin is going to sell both complete wedges (as they do now) and individual shafts. To implement this strategy, Zee Spin will create two profit centers: Wedges and Shafts. The Shaft profit center will produce shafts for external customers, as well as for the Zee Spin Wedge profit center. There will be two profit center managers in Zee Spin that will be rewarded based on the profits of their respective profit centers. The Zee Spin wedges will continue to be sold for $75 per complete wedge, while the shafts will be sold for $23 per shaft.
Shafts that are sold externally will incur variable selling costs of $2.43 (primarily sales commission and shipping). These costs are not incurred for shafts sold internally to the Wedge profit center.
Required:
a. The owners of Zee Spin want to maximize profits and realize that, to properly motivate the managers of the Wedges and Shafts profit centers, they need to set the proper transfer price for the shafts produced by the Shafts profit center and sold to the Wedges profit center. Using the actual data provided in the problem, what transfer price should be used for the shafts produced by the Shafts profit center and sold to the Wedges profit center? (Your answer should be a specific number, such as $18.00.)
b. After implementing the transfer price policy you described in part (a), what problems should the owners of Zee Spin anticipate? Stated differently, what non-firm-value maximizing behaviors by the two profit center managers should the owners of Zee Spin expect to occur?

Question 17

Creative Learning Centers
Creative Learning Centers (CLC), a for-profit firm, operates over 100 preschools primarily located in the northeast for children ages 4-6. CLC's innovative curriculum utilizes the latest technology and offers young minds creative expression, language and social skills, physical movement, music, and number skills-all provided by professional trained teachers. CLC leases buildings for their schools and invests substantial resources in leasehold improvements for classrooms, technology, and playground equipment. CLC's cost of capital is 12 percent. Typical tuition is about $6,300 per year for a five-day-a-week, four-hour-per-day program. Maria Schnelling manages 15 CLC schools in the state of Virginia. She has decision-making responsibility for staffing and operating her schools, as well as the responsibility for recommending adding new schools and closing existing schools. The following table provides current operating data on all of her 15 preschools, and breaks out her top- and bottom-performing schools:

"After-tax operating income" represents all revenues less all expenses (including depreciation and taxes but excluding any interest on debt to finance the investment) of running a school for the last 12 months.
Ms. Schnelling has identified three possible locations for new CLC preschools in Virginia (denoted as NVA1, NVA2, and NVA3).The following table provides current projected data on the three new preschools:

Required:
a. If Maria Schnelling is evaluated and rewarded based on after-tax operating income, which of her 15 existing schools will she recommend closing, and which of her three new schools will she recommend opening? (Justify your answers.)
b. If Maria Schnelling is evaluated and rewarded based on return on investment, which of her existing 15 schools will she recommend closing, and which of her three new schools will she recommend opening? (Show computations.)
c. You have been hired as a consultant to the board of directors to advise the board as to how CLC should measure and reward the performance of CLC managers, such as Ms. Schnelling in Virginia. How should CLC measure and reward its state managers? Provide a compelling rationale to support your recommendation. (Support your recommendation with relevant computations.)

Question 18

Warm Boots
Warm Boots manufactures and sells a patented ski boot with 9-volt batteries designed to keep a skier's feet warm even when the outside temperature reaches -10 °Celsius. Warm Boots is organized into three divisions: Administration (accounting, finance, human resources, CEO, and CFO), Manufacturing, and Marketing and Sales. To promote cost efficiency, Manufacturing is treated as a cost center, where its managweek times the actual average cost of manufacturing the boots in that week. The manager of M S has the discretion to set the price per pair of boots and is paid a bonus based on M S reported profits. The following table summarizes how price and total cost varies with the number of boots produced and sold PER WEEK. "Total Cost" includes both fixed and variable cost where the fixed cost is the annual fixed cost divided by 52 (the number of weeks in the year).

Required:
a. As the head of Manufacturing, how many boots will you manufacture if given the discretion to set production levels? Show calculations to support your answer.
b. If you managed the M S Division of Warm Boots, and given the production level (and its resulting average cost) chosen by the Manufacturing manager in part a, what price (and quantity level) would you choose for a pair of boots that maximizes your bonus? Show calculations to support your answer.
c. Given the decisions of the Manufacturing and M S managers in parts (a) and (b), is the firm maximizing profits? Explain why profits are or are not being maximized.

Question 19

University Lab Testing
Joanna Wu manages the University Lab Testing department within the University Hospital. Lab Testing, a profit center, performs most of the standard medical tests (such as blood tests) for other university clinical care units as well as for outside health care providers (independent hospitals, clinics, and physician groups). These outside health care providers are charged a price for each lab test using a predetermined rate schedule. University Hospital health care providers reimburse University Lab Testing using a transfer price formula. Roughly 70 percent of all Lab Testing procedures are performed for University Hospital units and the remainder for outside health care providers. Other lab testing firms in the community perform many of the same tests as Lab Testing. Lab Testing operates at about 85 percent capacity, on average. But when Lab Testing is operating at 100 percent of capacity, it must refuse outside work and even sends some inside- (University Hospital-) generated specimens to other community testing labs.
A standard blood test (code Q796) performed by Lab Testing has the following cost structure:

The predetermined rate paid by the outsiders (non-University Hospital health care providers) for this test (Q796) is $68.90.
Required:
a. Suppose Lab Testing has excess capacity. What transfer price maximizes University Hospital's profits?
b. Using the transfer price you chose in part (a), how much profit does Joanna Wu generate for her department if she performs one more Q796 test for an internal University Hospital user?
c. Suppose Lab Testing has no excess capacity. What transfer price maximizes University Hospital's profits?
d. Using the transfer price you chose in part (c), how much profit does Joanna Wu generate for her department if she performs one more Q796 test for an internal University Hospital user?
e. What transfer pricing policy should University Hospital implement regarding other University Hospital clinical care units reimbursing Lab Testing for Q796 blood tests? Be sure to describe the logic (and any administrative problems that you considered) underlying your proposed transfer pricing policy for Q796.

Question 20

Beckett Automotive Group
Beckett is a large car dealership that sells several automobile manufacturers' new cars ( Toyota, Ford, Lexus, and Subaru). Beckett also consists of a Pre-owned Cars Department and a large service department. Beckett is organized into three profit centers: New Cars, Pre-owned Cars, and Service. Each profit center has a manager who is paid a fixed salary plus a bonus based on the net income generated in his or her profit center.
When customers buy new cars, they first negotiate a price with a new car salesperson. Once they have agreed on a price for the new car, if the customer has a used car to trade in, the Pre-owned Cars Department manager gives the customer a price for the trade in. If the customer agrees with the trade-in price offered by Pre-owned Cars, the customer pays the difference between the price of the new car and the trade-in price.
Suppose a customer buys a new car for $47,000 that has a dealer cost of $46,200. The same customer receives and accepts $11,000 for the trade-in of her used car and pays the balance of $36,000 in cash (ignoring taxes and license). In this case, New Cars shows a profit of $800 (before any commission to the salesperson). If the customer does not accept the trade-in value, she does not purchase the new car from Beckett.
Once the deal is struck, the trade-in is then either sold by Pre-owned Cars to another customer at retail or is taken to auction where it is sold at wholesale. Continuing the preceding example, suppose the customer accepts $11,000 as the trade-in for her used car. The Pre-owned Cars Department can sell it on its used car lot for $15,000 at retail or sell it at auction for $12,000. If the trade-in is sold for $15,000, Pre-owned Cars would have a profit of $4,000 ($15,000 - $11,000). If it is sold at auction, Pre-owned Cars reports a profit of $1,000 ($12,000 - $11,000).
Required:
a. Describe some of the synergies that exist within Beckett. In other words, why does Beckett consist of three departments (New Cars, Pre-owned Cars, and Service) as opposed to just selling new cars, or just selling used cars, or just providing service?
b. What potential conflicts of interest exist between the New Cars and Pre-owned Cars department managers? For example, describe how in pursuing their own self-interest, the manager of New Cars or Pre-owned Cars will behave in a way that harms the other manager.
c. Suggest two alternative mechanisms to reduce the conflicts of interest you described in part ( b ).

Question 21

WBG
WBG manufactures and sells electronic transducers that are used in military and commercial products. WBG has three divisions: Transducer Division, Military Division, and Commercial Division. The Transducer Division designs and produces transducers that are sold externally as well as internally to the Military Division and the Commercial Division. Both the Military Division and the Commercial Division incorporate transducers in their final products that are sold to non-WBG end users. Because of the unique proprietary design of the WBG transducers, Military and Commercial Divisions only use WBG transducers in their products. All of WBG's sales are in the United States.
The three divisions are profit centers and about 50 percent of the Transducer Division output is sold externally, while the remainder is sold internally to the Military Division and the Commercial Division. WBG currently uses a full-cost transfer pricing policy for the transducers. The senior managers of the three divisions receive about 40 percent of their compensation tied to the performance of their division and the balance is received as base salary.
Because of the incessant bickering among WBG's three divisions' management teams over its current transfer pricing policy, the CEO of WBG attended a seminar on transfer pricing. After attending the seminar, the CEO proposed the following new policy for transducers: "Each month the transfer price of transducers will be the same as the external market price the Transducer Division receives for transducers sold to external customers, if, and only if, the Transducer Division is at capacity for the month. Otherwise, the transfer price is the Transducer Division's variable cost for the month."
Required:
You work for the CEO. Write a memo to the CEO that (a) explains the benefits of the proposed policy, (b) explains the likely changes in behavior among the three divisions that the new policy is likely to produce, and (c) states what additional data the CEO and you should collect and how you would analyze the data before making a decision regarding whether or not the new transfer pricing policy should be adopted.

Question 22

CJ Equity Partners
CJ Equity Partners is a privately held firm that buys small family-owned firms, installs professional managers to run the firms, and then sells them three to five years later, often for a substantial profit. CJ Equity is owned by four partners who raise capital from wealthy investors and invest this money in unrelated firms. Their aim is to provide a 15 percent rate of return on their investors' capital after paying the partners of CJ Equity a management fee. CJ Equity currently owns three operating companies: a tool and die company (Jasco Tools), a chemical bottling company (Miller Bottling), and a janitorial supply company (JanSan). The professional managers running these three companies are paid a fixed salary and bonus based on the performance of their company. Currently, CJ Equity is measuring and rewarding its three professional managers based on the net income after taxes of their individual companies. The following table summarizes the current year's operations of each of the three companies (all dollar amounts in millions):

CJ Equity charges each of the three operating companies an annual management fee of $200,000 for managing the companies, including filing the various tax returns. The weighted average cost of capital represents CJ Equity's estimate of the risk-adjusted, after-tax rate of return of similar companies in each operating company's industry.
You have been hired by CJ Equity as a consultant to recommend whether CJ Equity should change the way it measures the performance of the three companies (net income after taxes), which is then used to compute the professional managers' bonuses.
Required:
a. Design and prepare a performance report for the three operating companies that you believe best measures each operating company's performance and which will be used in computing the three professional managers' bonuses. In other words, using your performance measure, compute the performance of each of the three operating companies.
b. Write a short memo explaining why you believe the performance measure you chose in part (a) best measures the performance of the three professional managers.

Question 23

R D Inc.
R D Inc. has the following financial data for the current year (millions):

Assume the tax rate is zero.
Required:
a. R D Inc. writes off R D expenditures as an operating expense. Calculate R D Inc.'s EVA for the current year.
b. R D Inc. decides to capitalize R D and amortize it over three years. R D expenditures for the last three years have been $6.0 million per year. Calculate R D Inc.'s EVA for the current year after capitalizing the current year and previous years' R D and amortizing the capitalized R D balance.
c. In the specific case of R D Inc., how does capitalizing and amortizing R D expenditures instead of expensing R D affect the incentive for managers approaching retirement to underspend on R D at R D Inc.

Question 24

Flat Images
Flat Images develops and manufactures large, state-of-the-art flat-panel television screens that consumer electronic companies purchase and incorporate into a complete TV unit by adding the case, mounting brackets, tuner, amplifier, other electronics, and speakers. Flat Images has just introduced a new high-resolution, high-definition 60-inch screen. Flat Images is composed of two profit centers: Manufacturing and Marketing. Manufacturing produces sets that are sold internally to Marketing. Each profit center has the following cost structure:

Note that Marketing's fixed cost of $150,000 and variable cost of $200 per screen do not contain any transfer price from Manufacturing. The numbers in the preceding table consist only of their own costs, not any costs transferred from the other department. The selling price that Marketing receives for each 60-inch screen depends on the number of screens sold that month, according to the following table: 12

Required:
a. Suppose that Manufacturing sets a transfer price for each screen at $4,800. How many screens will Marketing purchase to maximize Marketing's profits (after Marketing pays Manufacturing $4,800 per screen) and how much profit will Marketing make?
b. At a transfer price of $4,800 per screen, and assuming Marketing buys the number of screens you calculated in part ( a ), how much profit is Manufacturing reporting?
c. At an internal transfer price of $4,800, and assuming Marketing purchases the number of screens you calculate in part ( a ), what is Flat Images' profit?
d. Given the cost structures of Manufacturing and Marketing, and the price-quantity relation given in the problem, how many 60-inch screens should Flat Image manufacture and sell to maximize firmwide profits?
e. If parts ( c ) and ( d ) are the same, explain why they are the same. If they are different, explain why they are different.
f. What transfer price should Flat Images set to maximize firmwide profits? (Give a quantitative number.)
12 An equivalent way to express the price-quantity relation in the table is P = $9,000 - 20 Q, where P = price and Q = quantity.

Question 25

Premier Brands
Premier Brands buys and manages consumer personal products brands such as cosmetics, hair care, and personal hygiene. Premier management purchases underperforming brands and redesigns to the mega-retail chains (Walmart and Kmart). Each product line manager is evaluated and rewarded based on return on net assets (RONA). RONA is calculated as net income divided by net assets where net assets is total assets invested in the product line less current liabilities in the product line [RONA = Net income/(Total assets - Current liabilities)]. For every 1 percent of RONA (or fraction thereof) in excess of 12 percent of the product line returns, the product line manager receives a bonus of $250,000. So, if a manager's RONA is 13.68 percent, his or her bonus is $420,000 [(13.68% - 12.00%) × 100 × $250,000]. Premier's weighted average cost of capital (WACC) is 12.43 percent.
Amy Guttman, one of Premier's three product line managers, manages a portfolio of four brands in the hair care business. These four brands currently generate a net income of $708,000, requiring $6.5 million of total assets and $1.3 million of current liabilities. Guttman is evaluating two possible brand acquisitions: Brand 1 and Brand 2. The following table summarizes the salient information about each brand (thousands).

Required:
a. Given Premier's incentive plan, will Amy Guttman acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.
b. Suppose that Premier's WACC is 15.22 percent instead of 12.43 percent, and the bonus system remains as described in the problem. How do Amy's decisions in part ( a ) change? Explain your answer.
c. Given the facts as stated in the problem, if you were the sole owner of Premier Products, would you acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.
d. Given the facts as stated in the problem, except that Premier's WACC is 15.22 percent instead of 12.43 percent, if you were the sole owner of Premier Products, would you acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.
e. Why do some companies use RONA instead of ROA (net income/total assets)? In other words, describe how the incentives generated by using RONA differ from the incentives from using ROA.

Question 26

Easton Electronics
Easton Electronics in Irvine, California, is a contract manufacturer that assembles complex solidstate circuit boards for advanced technology companies in the aerospace and health sciences industries. The contract manufacturing industry is very competitive in terms of pricing and performance (quality and on-time delivery). Outsourcing clients specialize in the design of sophisticated electronics products and then rely on their contract manufacturing partners (like Easton) to produce their designs. Once a new product is designed, the advanced technology firm solicits firm, fixed-price bids for the electronic components.
A completed electronic component consists of several assembled circuit boards, a box containing the boards, cables connecting the boards inside the box, cables connecting the box to other components, and exhaustive testing of the complete box build. The technology firm either solicits bids for each separate component (box, boards, and cables) or selects an integrated supplier that can deliver a completely assembled box that has been tested. After receiving the initial bids but prior to selecting the winning bidder, the technology firm selects two or three finalists and then spends considerable resources to qualify new suppliers by sending teams of engineers and purchasing specialists to inspect the bidders' manufacturing facility, procurement process, and quality programs.
Once a contract manufacturer is chosen, most clients are reluctant to switch to new suppliers because of the high search and startup costs of moving to a new supplier. Although some Easton customers source their metal boxes, boards, and cables from different contractors and then assemble the final electronic components into a complete unit that they test, most of Easton clients rely on Easton to provide a complete unit (box, circuit boards, connecting cabling, and final testing).
Easton has recently acquired a wholly owned cable company (TT Cabling). With the acquisition, Easton has two profit centers: Irvine (which manufactures the boards, builds the complete box, and assembles and tests it) and TT Cabling (which only makes and tests the cables). Currently, TT sells most of its cables to a different set of customers than those who have their boards built by Easton.
After the acquisition, Easton has a single sales force that sells board assembly, box build, and cables.
Easton assembles the electronic controller for a particular health imaging system for Scopics Imaging (SI). Easton manufactures the circuit boards, buys a sheet metal box designed specifically to house the boards, buys the cables to connect the boards within the box and other cables to connect the box to other components, tests the box, and delivers the completed unit to SI to plug the box intoits imaging system.
Irvine currently purchases four cables for the SI program. The following table summarizes Irvine's cost for ONE complete SI box:

Although Irvine purchases the cables for the SI program from an outside cable company, Easton senior managers are analyzing whether to have TT Cabling supply these cables. The managers of TT Cabling have submitted a bid to Irvine of $1,700 for the four cables in the SI assembly. The Irvine managers oppose buying the cables from TT because the TT bid of $1,700 is significantly higher than the outside cable supplier ($1,275). The bid of $1,700 submitted by TT for the four SI cables consists of variable costs of $1,000, fixed manufacturing costs of $300, and profits of $400.
The quality of the TT cables (including reliability of delivery schedule) is the same for both the TT cables and the outside supplier of cables.
When bidding on new proposals that involve complete box builds, Easton management wonders
whether they should continue to solicit price quotes from outside cable suppliers only, solicit bids from both outside cable suppliers and TT, or only get price quotes from TT Cabling.
Required:
Write a memo to the senior managers of Easton electronics proposing a policy that describes how Easton should decide whether to purchase cables externally or internally (through TT). The memo should describe the decision-making process, the relevant considerations, and the underlying objectives of such a policy. Use the SI cables as an example of how your Easton cable sourcing policy should be applied.

Question 27

Evergreen Nursery and Landscape
Evergreen Nursery and Landscape has two profit centers: Nursery and Landscape. Nursery buys young evergreen trees, grows them for a year, and then sells them to Landscape. Landscape then sells and plants them for residential customers. Nursery only sells its trees to Landscape, and Landscape only buys trees from Nursery. Landscape faces the following demand curve per month for planted trees by residential customers:

( Note: The demand curve in the table can be represented as P = 300 - 20 Q. )
Nursery has variable costs of $10 per tree and fixed costs of $210 per month. Landscape has variable costs of $50 per tree (before paying Nursery a transfer price for the tree) and fixed costs of $290 per month.
Required:
a. Assume the owner of Evergreen Nursery and Landscape knows all the costs of both divisions and the demand curve. If the owner sets the price for trees planted by Landscape, what final price for a planted tree would the owner set to maximize her profits and how many trees per month get planted?
b. Suppose the owner does not know the demand curve faced by Landscape, but she does know each division's fixed and variable costs. What transfer price would the owner set to maximize her profits?
c. Suppose that Nursery sets the transfer price at $75 per tree. How many trees will Landscape purchase from Nursery and plant per month in order to maximize Landscape's profits (including the transfer price of $75 per tree)?
d. What is Nursery's profit from setting a transfer price of $75, assuming Landscape maximizes its profits as in part ( c )?
e. Compare the firmwide profits that result from the transfer price chosen in part ( b ) and the firmwide profits that result from a $75 transfer price chosen in part ( c ), and explain why they are either the same or different.

Question 28

Transfer Price Company
The Transfer Price Company has two divisions (Intermediate and Final) that report to the corporate office (Corporate). The two divisions are profit centers. Intermediate produces a proprietary product (called " intermed ") that it sells both inside the firm to Final and outside the firm. Final can only purchase intermed from Intermediate because Intermediate holds the patent to manufacture intermed. Intermed's variable cost is $15 per unit, and Intermediate has excess capacity in the sense that it can
satisfy demand from both its outside customers and Final. Final buys one intermed from Intermediate, incurs an additional variable cost of $5 per unit, and sells the product (called " final ") to external consumers. Final faces the following demand schedule for final.

(The preceding demand schedule can be represented algebraically as: P = $500 - 20 Q.)
Required:
a. Calculate the quantity-price combination of final that maximizes firm value. In other words, if Corporate knew the variable costs of the two divisions, for what price would they sell final, and how many units of intermed would Corporate tell Intermediate to produce and transfer to Final?
b. Assume that the managers in Corporate do not know the variable costs in the two divisions. Intermediate has the decision rights to set the transfer price of intermed to Final. Intermediate knows Final's variable cost of $5 and the demand schedule Final faces for selling final to its customers. Intermediate, therefore, knows that the following schedule explains how many units of intermed Final will purchase given the transfer price Intermediate sets:

In other words, if Intermediate sets a transfer price of $260, Final will purchase six units of intermed and produce 6 units of final. Given the above schedule of possible transfer prices that Intermediate can choose, what transfer price will Intermediate set to maximize its profits?
c. While Corporate does not know intermed's variable cost, it does know that the total cost of intermed is $48 per unit. This $48 per unit cost consists of both the variable costs to manufacture intermed plus the allocated fixed manufacturing costs. Intermediate allocates all its fixed costs over all the products it produces, including intermed. If Corporate sets the transfer price of intermed at $48, how many units of intermed will Final purchase?
d. What is the dollar impact on Intermediate's profits if Final purchases the number of intermeds calculated in part ( c )?
e. Should Corporate allow Intermediate to set the transfer price for intermed that you calculated in part ( b ), or should Corporate set the transfer price at $48 as in part ( c )? Support your recommendation with a quantitative analysis.

Question 29

XBT Keyboards The keyboard division of XBT, a personal computer manufacturing firm, fabricates 50-key keyboards for both XBT and non-XBT computers. Keyboards for XBT machines are included as part of the XBT personal computer and are also sold separately. The keyboard division is a profit center. Keyboards included as part of the XBT PCs are transferred to the PC division at variable cost ($60) plus a 20 percent markup. The same keyboard, when sold separately (as a replacement part) or sold for non-XBT machines, is priced at $100. Projected sales are 50,000 keyboards transferred to the PC division (included as part of the XBT PC) and 150,000 keyboards sold externally. The keys for the keyboard are fabricated by XBT on leased plastic injection-molding machines and then placed in purchased key sockets. These keys and sockets are assembled into a base, and connectors and cables are attached. Ten million keys are molded each year on four machines to meet the projected demand of 200,000 keyboards. Molding machines are leased for $500,000 per year per machine; maximum practical capacity is 2.5 million keys per machine per year. The variable overhead account includes all of the variable factory overhead costs for both key manufacturing and assembly. Studies have shown that variable overhead is more highly correlated with direct labor dollars than any other volume measure.

Sara Litle, manager of the keyboard division, is considering a proposal to buy some keys from an outside vendor instead of fabricating them inside XBT. These keys (which do not include the sockets) will be used in the keyboards included with XBT PCs but not in keyboards sold separately or sold to non-XBT computer manufacturers. The lease on one of XBT's key injection-molding machines is about to expire and the capacity it provides can be easily shifted to the outside vendor.
The outside vendor will produce keys for $0.39 per key and will guarantee capacity of at least 2.5 million keys per year. Litle is compensated based on the profits of the keyboard division. She is considering returning one of the injection-molding machines when its lease expires and purchasing keys from the outside vendor.
Required:
a. How much will XBT save per key if it outsources the 2.5 million keys rather than producing them internally?
b. What decision do you expect Sara Litle to make? Explain why.
c. If you were a large shareholder of XBT and knew all the facts, would you make the same decision as Litle? Explain.
d. What changes in XBT's accounting system and/or organizational structure would you suggest, given the facts of the case? Explain why.

Question 30

Infantino Toyota
Infantino Toyota is a car dealership that has been in business for 40 years at the same 20-acre location selling and servicing new and "pre-owned" (used) Toyotas. Two years ago, Infantino Toyota replaced its aging showroom and service center with a new, state-of-the-art facility. When Ms. Infantino's father started the dealership, the business was on the outskirts of town. Now with city sprawl, the dealership is located on a busy commercial street surrounded by other dealerships, restaurants, and shopping centers.
The market for new cars is very competitive because many buyers shop on the Internet before visiting new car dealers. Once customers decide to purchase a new car from a dealer, they usually trade in their used car to avoid the hassle of selling the car themselves, and hence these new car buyers are willing to accept lower prices from car dealers for their trade-ins. Also, pre-owned cars have higher margins because there is less competition for used cars, as each used car differs in terms of mileage, condition, and options. Suppose a new car is sold for $45,000 ($500 over dealer cost) and the buyer receives a trade-in allowance on his old car of $8,000 and pays the difference in cash. That used car is then sold for $10,800. The dealer makes $500 on the new car and $2,800 on the used car. Infantino also offers parts and service for the new and pre-owned cars it sells.
Infantino Toyota is organized into three departments: New Cars, Pre-owned Cars, and Service. All three share the same building and lot where the new and used cars are displayed. Ms. Infantino compensates her three department heads based on residual income. After careful analysis by her financial manager, they determine that all three departments should be charged for the capital invested in their departments at 16 percent.
The new building cost $12 million and the land cost $900,000. The following table summarizes the land and building utilization by each department, each department's net income, and other net assets invested in each department:
For example, the new car department occupies 50 percent of the land and 30 percent of the building. It had net income of $600,000 and other assets of $2,500,000. Other assets consist of all inventories and receivables invested in the department. For example, the new car department has a substantial inventory of new cars. Each department's income consists of all revenues and expenses directly traceable to that department. Income taxes are not included in each department's net income reported in the table. Infantino Toyota uses the trade-in allowance of used cars taken in trade as the transfer price of used cars in calculating the net incomes of the new and pre-owned car departments.
Required:
a. Calculate the residual income of each of the three divisions of Infantino Toyota.
b. Discuss the relative profitability of the three departments. Which is making the most money and which is making the least amount of money?
c. Discuss whether the residual incomes of the three departments capture the true profitability of each department. What problems do you see in the way Ms. Infantino is evaluating the performance of the three department managers and of Infantino Toyota as a whole?

Question 31

Wujo
Wujo is a Shanghai company that designs high-end software to enhance and edit digital images. Its software, EzPhoto, is more powerful and easier to use than Adobe Photoshop, but sells at a much lower price. Currently, EzPhoto is written in Chinese for the Chinese market, but Wujo is entering the Englishspeaking market. This requires a substantial investment to convert EzPhoto to English. Wujo has established a UK wholly owned subsidiary (Wujo UK, or WUK for short) to sell EzPhoto to North American and European consumers-professional and serious amateur photographers. The following table displays the various combinations of prices and quantities it expects in sales of EzPhoto to English-speaking users:

For example, at a price of €270 it expects to sell 130,000 units of EzPhoto, or at €225 it can sell 175,000 units. To enter this market, WUK must spend €15 million to convert EzPhoto from Chinese to English, advertise EzPhoto, establish a website where purchasers can download EzPhoto, and hire an administrative staff to market and maintain the website. For each English version of EzPhoto sold, WUK expects to incur costs of €70 for sales commissions paid to third parties who market EzPhoto (e.g., Amazon, ZDNet.com, and Buy.com) and technical support for customers purchasing EzPhoto. EzPhoto will be distributed only via the WUK website. There are no packaging or CD-ROM costs.
WUK is evaluated and its managers compensated based on reported WUK profits. Wujo China, the parent company, is considering charging WUK a transfer price (actually a royalty) for each unit of EzPhoto WUK sells.
Required:
a. If Wujo China does not charge WUK a royalty for each unit of EzPhoto WUK sells (i.e., the transfer price is zero), what price-quantity combination will WUK select and how much profit will WUK make?
b. If Wujo China charges WUK a royalty of €50 for each unit of EzPhoto WUK sells (i.e., the transfer price is €50), what price-quantity combination will WUK select and how much profit will WUK make?
c. Ignoring any income taxes, what is the firm-value maximizing royalty (either zero euros or €50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Explain your answer.
d. Wujo (the parent) has to pay income taxes to the People's Republic of China (PRC) at the rate of 15 percent on any royalty payments it receives from WUK, while WUK faces a UK tax rate of 33 percent on profits of EzPhoto. Note that WUK's taxable income is calculated after deducting any transfer price (royalties) paid to Wujo. What is the firm-value maximizing royalty (either zero euros or €50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Whichever transfer price Wujo charges WUK (zero or €50), that transfer price is used to (1) measure and reward WUK managers, and (2) calculate income taxes in the PRC and the UK. Provide a detailed explanation supported by calculations justifying your answer.
e. Suppose that Wujo is able to use a different transfer price for determining WUK's profits (and hence the compensation paid to WUK management) than it uses for calculating income taxes on its PRC and UK tax returns. What transfer prices should Wujo use for calculating WUK's net income in determining WUK's managers' bonuses and for use on its two tax returns? The same transfer price has to be used on the two tax returns, but this transfer price need not be the same transfer price used for calculating WUK's income for management bonuses.
f. Why might you expect Wujo will be unable to implement the two transfer prices you propose in part (e)?