Madamburo PLC, a large multinational company, is undertaking a review of its organisational structure. Top management is concerned that the methods used for divisional performance evaluation and transfer pricing may be encouraging dysfunctional behaviour by division managers.
The following sample data is available concerning two of the company?s divisions for last year:
Division A Division B
Operating profit $152,000 $72,000
Capital invested $1,600,000 $576,000
The cost of capital is 7% for both divisions. It can be assumed that there are no intra-company transfers between Divisions A and B.
(a) Calculate the Return On Investment (ROI) and residual income for each division. Explain which of these two measures (ROI or residual income) gives the clearer indication of divisional contribution to the overall success of Madamburo PLC. (8 marks)
(b) Assume that ROI is used for divisional performance evaluation purposes. How would each of the two division managers react to an additional investment opportunity which would increase operating profit by $23,000 but would require capital investment of $220,000? Are their reactions in the best interests of the company?s shareholders? Justify your answer. (6 marks)
(c) At what cost of capital would the two divisions have the same residual income? (In answering this part, ignore the additional investment opportunity in part (b) above). (5 marks)
(d) Although there are no intra-company transfers between Divisions A and B, there are a significa nt number of intracompany transfers between other divisions of Madamburo PLC. Discuss the circumstances in which it is feasible and appropriate to use external market prices as the basis for setting transfer prices in such cases. (6 marks)