Clark Industries Ltd. manufactures monochromators that are used in a variety of applications. The Monochromator Division (M Division) sells its monochromators both internally and externally. It is operating at 80% of its 250,000 unit capacity and internal sales account for approximately 20% of its current sales volume. Internally the monochromators are transferred into the Aerospace Division (A Division) at a transfer price of $11,250 each. Variable production costs are the same for internal and external sales.
The income statement for the M Division is presented below:
Sales $2,850,000,000
Variable costs $900,000,000
Contribution Margin $1,950,000,000
Fixed Costs $1,360,000,000
Operating Income $590,000,000
The A Division uses one component in the production of its final product that sells for $75,000/unit. Other variable costs in the A Division are 40% of sales. and fixed costs per unit at its current capacity of 40,000 units are $17,250.
The Aerospace Division is operating at its full capacity of 40,000 units and is evaluating whether it should invest to increase capacity. The investment would cost $900,000,000 and would have a useful life of 3 years. The equipment could be sold for $800,000 at the end of its useful life. For tax purposes it would be sold on January 1 of year 4. The machine would be used to manufacture a variation of its current product with the same transfer price. This new product would sell for $68,000 per unit. The variable cost ratio will be 45% of the selling price. The additional capacity of the new machine would be 14,000 units. It would qualify for a 30% CCA rate and the company would continue to have assets in the pool.
Required:
a. Evaluate the current transfer pricing policy from the standpoint of each division manager as well as the company as a whole.
b. Using net present value (NPV) analysis, would the A Division manager want to invest in the new equipment if the required rate of return is 12% and the tax rate is 25%?
c. If the investment is evaluated from a corporate perspective using NPV analysis and the 12% discount rate, does the decision change? Explain.
Quick Reply
