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Case - MCS
Case - MCS
For the
coming financial year, the target rate of return for the divisions and for the company as a whole is 15%.
The Wood Division (WD) purchase logs and produces finished timber as planks or beams. Approximately two-thirds
of its output is sold to the Products Division, with the remainder sold on the open market.
The Product Division (PD) manufactures wooden garden furniture. The policy of 4Es plc. is that the PD must buy all
its timber from WD and sell all its output to the Trading Division.
The Trading Division (TD) sell wooden garden furniture to garden centres, large supermarkets, and similar outlets. It
only sells items purchased from PD.
The current position is that all three divisions are profit centres and 4Es plc uses Return on Investment (ROI)
measures as the primary means to assess the divisional performance. Each division adopts a cost-plus pricing policy
for external sales and for internal transfers between divisions. Mr. Dumay, financial controller of 4Es plc. has stated
that the divisions should consider themselves to be independent businesses as far as possible.
The wood division currently has an annual return on investment (ROI) of 20% on its investment base of $1,200,000.
The following additional projects are being considered:
Project Investment outlay EBIT ROI%
A $300,000 $100,000 33
B $700,000 $210,000 30
C $500,000 $130,000 26
D $200,000 $44,000 22
Division WD is planning to produce 15,600 units (normal capacity). Variable cost per timber is $30 while fixed
production costs of $150,000 are expected in Division WD. Division WD allocates fixed costs on the basis of normal
capacity, regardless of actual production. The sales price for external sales is $55 per unit. For the purposes of
internal pricing the manager of Division WD sets a profit mark-up of 50% on full absorption cost in order to earn a
satisfactory return on divisional assets employed, $1,200,000.
Division PD has in the past purchased all its timber from Division WD. Division PD's costs consist of the transfer-in
cost, additional variable production costs of $48 per furniture, and $160,000 fixed production costs which are
allocated to furniture on an expected annual production basis. Division PD plans to produce 12,000 furniture
products in the coming year. Division PD sells the finished products to Division TD for $180 each. Assets employed
in Division PD total $1,140,000. An external supplier has offered to provide 12,000 of Division PD's timber
requirement for the coming year at a price of $45.
If no new capital expenditure transactions take place, the forecast results for next year are:
Division Capital employed at beginning year Net profit for year (after depreciation)
TD 2,500,000 550,000
Division TD could invest $450,000 now in a new asset so as to increase net profit by $81,000 per annum for five
years. The asset is not expected to have any scrap value.
Required:
1. Which combination of investments will maximize the wood division’s return on investment assuming no
capital rationing is in place?
2. Evaluate whether or not the appropriateness of ROI as a performance measure for the manager of Division
TD. If having risks, advise how these risks may be mitigated.
3. Should Division PD buy its timber from the external supplier or from Division WD? Why?
4. For each division suggests, with reasons, the behavioral consequences that might arise as a result of the
current policy for the structure and performance evaluation of the divisions.
5. The financial controller of 4Es plc. has requested a review of the cost-plus transfer pricing policy that is
currently used. Suggest with reasons, an appropriate transfer pricing policy that could be used for transfer
from PD to TD, indicating any problems that may arise as a consequence of the policy you suggest.
Answer:
1/ 1. *Project B and C: Investment= 500000+700000=1200000
EBIT=210000+130000=340000
ROI=340000/1200000=28.33%
*Project A, B and D: Investment=300000+700000+200000=1200000
EBIT=100000+210000+44000=354000 R
OI=354000/1200000=29.5%
=>Project A, B, D will maximize the wood division’s return on investment
2/ It is appropriate to use ROI as a performance metric for a TD Department manager. Because we control costs
center, profits center and investment center at the same time.
3/ The total variable cost = 48 * 12,000 = 576,000
The total price from external supplier = 45 * 12,000 = 540,000
So the division PD should buy from external supplier.
4/ 4Es plc's senior management stated that the three departments should treat themselves as independent businesses
as much as possible. However, the main problem is that they are highly correlated and interdependent. WD sells
approximately two-thirds of its production to PD. Therefore, the profit of WD and PD mainly depends on the cost-
plus transfer price. In addition, only one-third of output is sold to external customers, and these internal transfers will
significantly affect the ROI measures used to evaluate performance. This can cause various behavioral problems,
including:
• Attempts to manipulate internal pricing procedures, especially by increasing costs;
• Lack of effort and motivation to control costs;
• Lack of efforts to sell to external customers because the consequences may be small
Related to internal transfer;
• Short-term decisions may come at the expense of long-term profits.
PD must sell all of its products to TD and purchase all of its wood from WD. So the question The WD mentioned is
more suitable for PD. It has almost no control over its business activities, so it cannot really be regarded as an
independent business. Additional behavioral consequences of PD include:
• The main focus of PD should be quality and technical efficiency. Control pass The return on investment may be
distracting at best, and at worst may conflict with this goal. For example, do not replace the machine, because it will
worsen the return on investment.
• PD needs to work closely with WD and TD and act as an independent Profit centers may inhibit this (perhaps cost
centers will be more appropriate?) TD sales to the final market, so its sales revenue will not be unduly affected by
the structure C. Its main cost is determined by internal transfer, so its return on investment is not a good measure
Performance, just like the other two departments. Other consequences of behavior include:
• If the transfer cost from PD means overall profit and return on investment, then the motivation issue Low.
• If TD’s management believes it can substantially increase sales and Improve the return on investment by having a
wider range of products.
5/ Generally speaking, the transfer price should reflect the market price. There are many theories and evidence that
Such a price will minimize the possible consequences of bad behavior. Where is market based Price is impossible,
and all transfer prices have potential problems. Many transfer prices The theory attempts to determine transfer prices
that may be similar to market prices.
Transfer from PD to TD
Here is a good example, that is, PD is not actually a profit center. It cannot control its output, nor can it trade outside
of 4Es plc. On a purely economic standard, PD should become a cost center and transfer its output to TD at cost.
From an economic point of view, there is a theoretical argument that this transfer price should be marginal cost. In
order to achieve this goal, PD's performance measurement and reward system must be changed, because the transfer
of marginal costs will always produce "losses" in the supply sector. In practice, transfers are more likely to be full
costs or standard costs. If this is the case, PD's performance goal will be to break even. TD may receive these
products at below market prices. This may result in a lower final price and an increase in demand. Need to be
careful, because this higher output may result in an increase or decrease in profits.
It is possible to accurately estimate prices based on the market. If this is the case, it is possible to run the current
structure. From the limited evidence, it is unlikely that market-based prices can be obtained reliably.