Alpha and Beta: divisional performance and transfer pricing

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• Alpha ROI before = 600,000 / 3,000,000 = 20.0%, and Beta ROI before = 450,000 / 1,800,000 = 25.0%.
• Alpha RI before = 600,000 - 12% x 3,000,000 = $240,000, and Beta RI before = 450,000 - 12% x 1,800,000 = $234,000.
• Alpha's project returns 18% (180,000 / 1,000,000). Alpha ROI after = 780,000 / 4,000,000 = 19.5%, which is below 20.0%, so the manager would reject it under ROI.
• Alpha's project RI = 180,000 - 12% x 1,000,000 = $60,000, and RI after = $300,000, so it would be accepted under RI.
• Beta's project returns 15% (90,000 / 600,000). Beta ROI after = 540,000 / 2,400,000 = 22.5%, which is below 25.0%, so the manager would reject it under ROI.
• Beta's project RI = 90,000 - 12% x 600,000 = $18,000, and RI after = $252,000, so it would be accepted under RI.
• Both projects earn more than the cost of capital of 12 percent, so both are in the interest of the group.
• The results show that using ROI may lead managers to reject projects that the group should accept.
• Alpha's project earns 18 percent, which is 6 percentage points above the 12 percent cost of capital, and Beta's earns 15 percent, 3 points above it.
• The workings are set out in a clear table for each division, before and after the project.

Marks counted: 0 of 10

Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• ROI is a percentage, easy to understand and to compare between divisions of different sizes.
• ROI may cause managers to reject projects with a return above the cost of capital but below the division's current ROI, or to dispose of assets to raise ROI.
• RI is an absolute amount, so any project that earns more than the cost of capital increases it, which encourages goal congruence.
• RI is harder to compare between divisions of different sizes, and it depends on the cost of capital chosen.
• Recommendation: use RI (or both measures), and base the bonus on controllable profit, with appropriate non-financial targets.

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Tick each point that your answer made clearly and only once. Points here are this site's own. A real examiner may accept other valid points.

• (a) With spare capacity, there is no opportunity cost, so the minimum transfer price is the variable (marginal) cost of $30.
• (b) At full capacity, each unit transferred loses an outside sale, so the minimum price is marginal cost $30 plus opportunity cost (the lost contribution of $50 - $30 = $20), which is $50.
• The maximum price Beta would pay is the lower of its outside purchase price ($48) and the net revenue from using the component. Here this is $48.
• In case (a), the transfer price range is $30 to $48, and a transfer is in the group's interest, so the price should be negotiated within it.
• In case (b), the minimum price of $50 is above the maximum price of $48, so no transfer should take place, and Beta should buy outside, which is best for the group.
• In case (b) the group is better off if Alpha sells outside at $50 and Beta buys outside at $48, a gain of $2 a unit, so a cost-based transfer price of $30 would lead Beta to buy internally and give a poor decision for the group.

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