Comprehensive case (LO 2, 3, 4, 5) Thompson Manufacturing has been in business for over 50 years, making a variety of consumer electronics products. Mary Felix recently joined the business as vice president of the Conley division, one of the company's newest divisions. During her first week on the job, Mary met with CEO Mitch Thompson to discuss the division's future.
"I know we're one of the newest and smallest divisions in the company," Mary said, "but I think we're in a position to realize some dramatic growth through product line expansion. We've got a full pipeline of products under development, and I'd like to speed up development of a couple of those products. If we work hard, I think we can have the new MP3 express charger ready for release by the end of the year."
Mitch thought for a minute and then replied. "That sounds like a good idea, Mary. I just don't want you to move so fast that you don't have a good understanding of how the introduction of the new product will impact the division's performance. Remember, I'm a big fan of maintaining our return on investment."
Mary went back to her office after the meeting and began to crunch the numbers on the express charger. At a price of $10 per unit, the marketing department estimates demand for the product at 40,000 units. The division will need to purchase a new machine for $100,000 to produce the charger. Mary also estimates that the division will incur an additional $140,000 in fixed costs that are directly attributable to the charger.
One component of the charger is currently produced by Thompson's Amber division at a variable cost of $3 per unit. The component is sold to outside customers for $5 per unit. Mary had met with Caroline Smith, vice president of the Amber division, earlier in the week to discuss the possibility of the Amber division supplying the component to the Conley Division. "Sure," Caroline began, "I'd like to help you out on this. We can provide the components at our market price of $5 per unit. We have the capacity to make 150,000 of the components, and we're currently making only 135,000 for our external customers." Mary thanked Caroline for her time saying, "I'll get back to you next week."
The Conley division currently earns $250,000 on $2.5 million in sales revenue. The division has an asset base of $1,250,000. Mary knows that Mitch will not be happy if the new product reduces the division's return on investment, and she is concerned that Caroline's offer to sell the component at $5 per unit will push product costs too high to maintain the division's ROI. She thinks that if she can meet with Caroline again to explain the situation, maybe she can negotiate a lower transfer price.
Required
a. What is the Conley division's current return on investment?
b. Given the projected demand for the charger and the current cost estimates for the product, what is the maximum total variable cost that Mary can incur and still maintain the division's ROI? What would be the resulting contribution margin per unit for the charger?
c. What is the minimum transfer price that the Amber division should be willing to charge the Conley division for the 40,000 components it needs to produce the charger?
d. Regardless of your answer to part (b), assume that Mary has determined that the maximum acceptable variable cost per unit is $6 and that all but $2 of that cost will be attributable to the component transferred from the Amber division. Will Mary accept the Amber division's minimum transfer price?
e. Suppose that Mitch has decided to evaluate divisional vice presidents based on residual income rather than return on investment. If he requires a 14% minimum rate of return, will Mary be able to accept the Amber division's minimum transfer price? Why or why not?
f. What do you recommend?