Question

CLUK is a producer of sports nutrition drinks and has two divisions, D1 and D2. Division D1 manufactures recyclable plastic containers which it sells to both Division D2 and also external customers. Division D2 makes high protein drinks which it sells to the retail trade in the containers that it purchases from Division D1.

You have been provided with the following budget information for Division D1:

	$
Selling price to retail customers per 1,000 containers	130
Variable costs per container	0.04
Fixed Costs per annum	2.4 million
Net Assets	4.0 million

Production capacity	40,000,000 containers
Retail demand for containers	38,000,000 containers
Demand for containers from Division D2	20,000,000 containers

You have been provided with the following budget information for Division D2:

	$
Selling per container of protein drink	0.50
Variable costs per drink (excluding container)	0.15
Cost per container (from Division D1)	At transfer price
Fixed Costs	1,750,000
Net assets	12,650.000
Sales volume of protein drinks in containers	20,000,000

Transfer Pricing Policy

Division D1 is required to satisfy the demand of Division D2 before selling containers externally. The transfer price for a container is full cost plus 20%.

Performance Management Targets

Divisional performance is assessed on Return on Investment (ROI) and Residual Income (RI). Divisional managers are awarded a bonus if they achieve the annual ROI target of 25%. CLUK has a cost of capital of 7%.

Required:

REQUIRED:

(a) Produce a three-page PowerPoint presentation to incorporate the following tasks:

(i) SLIDE 1

Using Excel, produce a profit statement for each division detailing sales and costs, separating external sales and inter-divisional transfers. You are advised to produce this statement in a Excel spreadsheet first and then copy this information into the PowerPoint slide

(ii) SLIDE 2

Using Excel, calculate the ROI for division D1 and division D2. Copy this information into Slide 2 of the PowerPoint presentation

(iii) SLIDE 3

Provide a brief commentary on the divisionalised profit statements and ROI results shown in slides 1 and 2

Answer 1

Slide 1

Profit statement for each division Particulars Division 11 Division D2 Working Note - Calculation of transfer price Sale to Outside Transfer to D2 Selling Price per unit 10.13 Particulars Total Variable Cost (40,000,000*0.04) Total Fixed Cost Transfer Price (Refer working note) 0.12 Amount 1,600,000 2,400,000 4,000,000 Variable cost per unit 0.04 0.04 0.15 Total Cost Contribution per unit 0.09 0.08 0.35 Profit at 20% 800,000 Total 4,800,000 Total Units 20,000,000*20,000,000 20,000,000 40,000,000 Total number of units Transfer Price 0.12 Total contribution 1,800,000 1,600,000 7,000,000 Gross Contribution of Division D1 3,400,000 Fixed Costs 2,400,000 1,750,000 Net profit/(loss) 1,000,000 5,250,000 *Since the capacity is limited to 40 million units in Division D1.

Slide 2

Calculation of ROI of both the divisions Particulars Divison D1 Division D2 Total Profit as calculated in Silde 1 1,000,000 5,250,000 Net Assets 4,000,000 12,650,000 (C) = A/B ROI 25% 42%

Slide 3

A brief commentary on the divisionalised profit statements and ROI results As we can see in the question, in case of Division D1, production capacity is the limiting factor. As per the company's policy, Division A is supposed to fulfill the demand of Division D2 at first before selling the product in the market. The transfer price between the divisions is 0.12 which is less than the actual price in the market. This results in decreasing the profit margin for Division of D1 and lower cost for Division D2. As the divisional performance is assessed based on the ROI and residual income of the division, it would result in benefit for the manager of D2 and loss for the manager of D1. This could lead into conflicts between the two departments. The company should allocate the transfer price to D1 in line with the external selling price to maintain fairness between the departments. The market ROI is 7%. In comparision, both the divisions are in profitable position as shown in Slide 2. Division D2 provides almost double the ROI as in the Division D1. Therefore, the company should focus on expanding the capacity of D2 in order to increase in profits, but after considering the market demand of the product