# The over arching point is that variations in

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The over-arching point is that variations in measurement affect the ranking of divisions. We need to pay attention to the purpose of the ranking and use the appropriate measure for the decision at hand . Thus, if we are deciding whether to keep or sell the asset, current market value is the choice as it best reflects the opportunity cost of retaining the asset. 12.59 The main difficulty in this problem is calculating profit for the year 2013. We know that revenue will be \$3 million. We also know that COGS and selling expenses both are mixed costs (i.e., con- tain both fixed and variable components). We need to break these portions out to generate an ac- curate profit estimate. Let us use the high-low method (see Chapter 4) to estimate the COGS and selling expenses at the projected sales level. We can write COGS as: \$1,800,000 = COGS fixed + Variable cost per sales \$ × \$2,400,000 \$2,010,000 = COGS fixed + Variable cost per sales \$ × \$2,700,000 Subtracting one equation from the other, we can calculate the variable portion as: Variable cost per sales \$ = (\$2,010,000 -\$1,800,000)/ (\$2,700,000 - \$2,400,000) = \$210,000 / \$300,000 = 70%. Balakrishnan, Sivaramakrishnan, & Sprinkle – 2e FOR INSTRUCTOR USE ONLY 12-20
We can then use either equation to calculate COGS fixed as \$120,000 = \$1,800,000 - (0.7 × \$2,400,000). We can perform similar computations for selling expenses to calculate the variable selling cost at 10% of each sales \$ and the fixed selling cost at \$240,000. With these data in hand, we can project the income statement for 2013. Year 2013 Sales \$3,000,000 Given Cost of goods sold 2,220,000 \$120,000 + (0.7 × \$3,000,000) Gross margin 780,000 Selling expenses 540,000 \$240,000 + (0.1 × 3,000,000) Profit before tax \$240,000 Then, the ROI is (\$240,000 / \$2,275,000) = 10.55%. The division’s residual income is \$240,000 – (0.1 × \$2,275,000) = \$12,500 12.60 a. With the current arrangement, we would argue that Raja should be evaluated as a cost center . He exercises limited control over revenues – the buying divisions determine the quantities and the HQ determines the “price” per unit. b. This is a tricky question to answer. It really depends on whether Raja has the ability to downsize his plant to 900,000 units. In other words, why did the unused capacity of 300,000 cans arise and what can we do about it? If the capacity arose because demand fluctuates (peak demand > 1.2 million cans), then the buying divisions should bear the cost. Dividing by actual use accom- plishes this purpose. If, on the other hand, a practical capacity of 900,000 is indeed feasible, then the transfer price should be based on practical capacity of 1.2 million. This way, the pricing does not pass on Raja’s inefficiency to the buying plants. Rather, the cost of the unused capacity is separately recognized and reported for managerial action. c. In general, having market price as the transfer price provides the cleanest economic signals. Here, this use will generate a loss of 900,000 * 1.50 – (\$450,000 + \$1,080,000) = \$180,000 in Raja’s division. This loss comingles the cost of the unused capacity plus any inefficiency in Raja’s operation. This amount is the “cost” that management has to tradeoff with the “benefit” of having a captive supplier of cans for the paint divisions.