MADM – IN-CLASS QUIZ

QUESTION 1

The Questron Company manufactures telecommunications equipment at its plant in Scranton,

Pennsylvania. The company has marketing divisions throughout the world. A Questron
marketing division in Hamburg, Germany, imports 100,000 broadband routers from the United
States. The following information is available:

Suppose the United States and German tax authorities only allow transfer prices that are
between the full manufacturing cost per unit of $400 and a market price of $475, based on
comparable imports into Germany. The German import duty is charged on the price at which
the product is transferred into Germany. Any import duty paid to the German authorities is a
deductible expense for calculating German income taxes.

Required:

1. Calculate the after-tax operating income earned by the United States and German divisions
from transferring 100,000 broadband routers (a) at full manufacturing cost per unit and (b)
at market price of comparable imports. (Income taxes are not included in the computation
of the cost-based transfer prices.)
2. Which transfer price should the Questron Company select to minimize the total of company
import duties and income taxes? Remember that the transfer price must be between the
full manufacturing cost per unit of $400 and the market price of $475 of comparable
imports into Germany. Explain your reasoning.

SOLUTION
1. Solution Exhibit 22-23 shows the after-tax operating incomes earned by the U.S. and
German divisions from transferring 100,000 broadband routers using (a) full manufacturing cost
per unit, and (b) market price of comparable imports as transfer prices.

2. There are many ways to proceed, but the first thing to note is that the transfer price that
minimizes the total of company import duties and income taxes will be either the full
manufacturing cost or the market price of comparable imports.
Consider what happens every time the transfer price is increased by $1 over, say, the full
manufacturing cost of $400. This results in the following change for each unit:

a. an increase in U.S. taxes of 35%  $1 $0.35

b. an increase in import duties paid in Germany, 15%  $1 0.15

c. a decrease in German taxes of 40%  $1.15

(the $1 increase in transfer price + $0.15 paid by way

of import duty) (0.46)

Net effect is an increase in import duty and tax payments of: $0.04

To verify this solution, note that if the transfer price changes from $400 to $475, the net effect
is an increase in import duty and tax payments of ($475 – $400) × $0.04 = $3 per unit. Across
100,000 units, this implies a decrease in total profits of (100,000) × $3 = $300,000, which
corresponds exactly to the $300,000 difference in total after-tax operating incomes
documented in Solution Exhibit 22-23.

Therefore, Questron Company will minimize import duties and income taxes by setting the
transfer price at its minimum level of $400, the full manufacturing cost.
SOLUTION EXHIBIT 22-23

Division Incomes of U.S. and German Divisions from Transferring 100,000 broadband routers

Method A
Method B
Internal Transfers
Internal
at Full
Transfers at
Manufacturing Cost Market Price
U.S. Division

Revenues:

$400, $475  100,000 units $40,000,000 $47,500,000

Costs:

Full manufacturing cost:

$400  100,000 units 40,000,000 40,000,000

Division operating income 0 7,500,000

Division income taxes at 35% 0 2,625,000

Division after-tax operating income $ 0 $ 4,875,000

German Division

Revenues:

$575  100,000 units $57,500,000 $57,500,000

Costs:

Transferred-in costs:

$400  100,000, $475  100,000 units 40,000,000 47,500,000

Import duties at 15% of transferred-in price

$60  100,000, $71.25  100,000 units 6,000,000 7,125,000

Total division costs 46,000,000 54,625,000

Division operating income 11,500,000 2,875,000

Division income taxes at 40% 4,600,000 1,150,000

Division after-tax operating income $ 6,900,000 $ 1,725,000

Sum of divisional after-tax operating incomes $ 6,900,000 $ 6,600,000

QUESTION 2

Munich Partners provides a diverse array of back office services to its clients in the financial
services industry, ranging from record keeping and compliance to order processing and trade
settlement. Munich has grown increasingly reliant on technology to acquire, retain, and serve
its clients. Worried that its spending on information technology is getting out of control,
Munich has recently embraced variance analysis as a tool for cost management.

After some study, Munich determines that its variable and fixed technology overhead costs
are both driven by the processing time involved in meeting client requests. This is typically
measured in CPU units of usage of a high-performance computing cluster. Munich’s primary
measure of output is the number of client interactions its partners have in a given period.

The following information pertains to the first quarter of 2014 (dollars in thousands):

Required:

1. Calculate the variable overhead spending and efficiency variances, and indicate whether
each is favorable (F) or unfavorable (U).
2. Calculate the fixed overhead budget variance and indicate whether it is favorable (F) or
unfavorable (U).

SOLUTION

SOLUTION

1. and 2. Variable and Fixed Technology Overhead Variance Analysis for Munich Partners
for the first quarter of 2014
 Flexible Budget: Allocated:

Budgeted Input Qty. (Budgeted Input Qty.

Allowed for Allowed for

Actual Input Qty. Actual Output

Actual Output
Actual Costs
 Budgeted Rate  Budgeted Rate
Incurred  Budgeted Rate)

Variable

Technology (4,000  $1.5) (15,000 0.2  $1.5) (15,000 0.2  $1.5)

Overhead $5,500 $6,000 $4,500 $4,500

$500 F $1,500 U

e. Spending variance f. Efficiency variance Never a variance

Fixed (15,000  0.2  $4)

Technology $12,200 $11,200 $11,200 $12,000

Overhead

$1,000 U $800 F

h. Spending variance Never a variance g. Production volume variance

3. Munich Partners has done a reasonable job overall of managing its technology overhead
costs. It has an unfavorable variable overhead efficiency variance because it used too many CPU
units of processing time relative to the number of client interactions it had. This is not an issue
if the goal was to meet the high-performance computing needs of clients and resulted in higher
levels of client satisfaction or revenues. For the 4,000 CPU units used, Munich Partners spent
$1.375 per unit relative to the budgeted $1.50, so the price/spending variance on variable
technology overhead was favorable.

From the standpoint of capacity utilization, Munich Partners were successful at

managing their fixed technology overhead resources. They handled 15,000 client interactions,
compared to an expected output of 14,000. It would be useful to know what the firm views as
the maximum attainable level of capacity given its current spending on technology. This is
particularly significant because Munich Partners spent an additional $1,000 more than the
expected expenditure on fixed resources for the period. The firm should attempt to identify the
causes of this negative spending variance and assess whether this higher spending level is likely
to persist in future years.

QUESTION 3

Chiang Rai Forest Company (CRFC), a very large integrated wood and lumber products company with
substantial timber holdings, has two divisions: Forest and Lumber. Forest division manages the timber
holdings, maintains the land and plants and harvests trees. Forest Division’s total asset value is stated on
CRFC’s balance sheet as $2.2 billion. Most of the timber the Forest division harvests is sold internally to
the Lumber division. Any timber not sold to the Lumber division can be sold externally. The Lumber
division can purchase the timber from outside suppliers at the market price, but has sourced internally
during the past few years. Last year, the Forest division sold 200 million board feet of timber to external
customers at $4.50 per board foot. A board foot is a standard unit of measure in the timber business.
Forest division sold another 800 million board feet of timber to the Lumber division. The Forest
division’s operating expenses last year totaled $2 billion.

The Lumber division only purchases timber from the Forest division. The company (CFRC) has decided
that the purchase price paid by Lumber to Forest should be computed as Lumber’s proportionate share
of Forest’s operating costs. The share of operating cost is based on Lumber’s fraction of Forest’s total
board feet harvested. That is, the transfer price is

(# of board feet purchased by Lumber from Forest/ Total # of board feet produced by Forest) x Total
operating cost of Forest

Lumber sells the timber after cutting and processing. Lumber’s total revenues are $7.6 billion, other
operating expenses (excluding the cost of timber) are $3.5 billion and assets are $2.7 billion,
respectively.

CRFC uses Residual Income to evaluate and reward the performance of the senior managers of the two
divisions. The required rate of return used in the calculation is 15% for Forest and 20% for Lumber. The
manager who consistently shows the better divisional performance is most likely to be promoted to the
General Manager position.

Required

1. Calculate the residual income for both divisions based on current transfer price. You may ignore
income taxes.
2. Assume that Forest division can sell all its output in the open market. Based on the optimal
transfer price, what is the residual income of both divisions?

SOLUTION
1. The following table calculates the RI ($ billions) for the two divisions.

Forest Lumber

Division Division Total

Revenues:

Inside $1.600*

Outside 0.900 $7.600

Total revenues $2.500 $7.600

Expenses

Timber purchases 1.600*

Operating expenses 2.000 3.500

Net Income $0.500 $2.500

Weighted average cost of capital 15% 20%

Total assets 2.200 2.700

Cost of capital invested $0.330 $0.540

RI $0.170 $1.960 $2.130

*(800 million ÷ 1 billion board feet) × $2 billion (Forest Division operating expenses)
2. The Lumber Division appears to be the more profitable of the two divisions.

Lumber appears more profitable because it is not paying the opportunity cost of timber.
The Forest Division can sell its timber externally at $4.50 per board foot, and in fact sold
20 percent of its timber that way. The Lumber Division is only paying $2.00 per board
foot ($1.60 billion ÷ 800 million board feet). Thus, Lumber’s profitability is being
increased by $2.50 per board foot due to the cost-based transfer-pricing scheme
employed. If Lumber cannot sell all its output in the open market then using the market
price may be too high. However some intermediate price between the variable cost and
market could be used. The key point is that Lumber is subsidizing Forest.

3. CRFC should consider going to a market-based transfer price to better assess the
opportunity cost of the timber transferred. Also, this will give Lumber the incentive to
buy one more board foot of timber as long as it can sell it for at least $4.50 net of its
variable costs. This represents an upper bound on the transfer price that Forest should
charge Lumber (depending on Forest’s capacity utilization). Using market price to
transfer timber produces the following EVA calculations, which show that Lumber could
actually be reducing firm value.
 Forest Lumber

Division Division Total

Revenues:

Inside $3.600*

Outside 0.900 $7.600

Total revenues $4.500 $7.600

Expenses

Timber purchases 3.600*

Operating expenses 2.000 3.500

Net Income $2.500 $0.500

Weighted average cost of capital 15% 20%

Total assets 2.200 2.700

Cost of capital invested $0.330 $0.540

RI $2.170 ($0.040) $2.130

*
800,000 × $4.50

However, if CRFC uses a market-based transfer price, it will have to adjust the compensation
plan to avoid giving Forest Division managers a wind-fall gain and the Lumber Division a wind-
fall loss.

If CRFC does not make adjustments to the transfer pricing scheme, managers may be de-
motivated at Forest division.