Cluk Is A Producer Of Sports Nutrition Drinks And Has Two Di

Cluk Is A Producer Of Sports Nutrition Drinks And Has Two Divisions D

Cluk is a producer of sports nutrition drinks and has two divisions, D1 and D2. Division D1 manufactures recyclable plastic containers which it sells to both Division D2 and external customers. Division D2 makes high protein drinks which it sells to the retail trade in the containers that it purchases from Division D1. You have been provided with the following budget information for Division D1: $ Selling price to retail customers per 1,000 containers 130 Variable costs per container 0.04 Fixed Costs per annum 2.4 million Net Assets 4.0 million Production capacity 40,000,000 containers Retail demand for containers 38,000,000 containers Demand for containers from Division D,000,000 containers You have been provided with the following budget information for Division D2: $ Selling per container of protein drink 0.50 Variable costs per drink (excluding container) 0.15 Cost per container (from Division D1) At transfer price Fixed Costs 1,750,000 Net assets 12,650.000 Sales volume of protein drinks in containers 20,000,000 Transfer Pricing Policy Division D1 is required to satisfy the demand of Division D2 before selling containers externally. The transfer price for a container is full cost plus 20%. Performance Management Targets Divisional performance is assessed on Return on Investment (ROI) and Residual Income (RI). Divisional managers are awarded a bonus if they achieve the annual ROI target of 25%. CLUK has a cost of capital of 7%. Required:

REQUIRED:

(a) Produce a three-page PowerPoint presentation to incorporate the following tasks:

(i) SLIDE 1 Using Excel, produce a profit statement for each division detailing sales and costs, separating external sales and inter-divisional transfers. You are advised to produce this statement in a Excel spreadsheet first and then copy this information into the PowerPoint slide

(ii) SLIDE 2 Using Excel, calculate the ROI for division D1 and division D2. Copy this information into Slide 2 of the PowerPoint presentation

(iii) SLIDE 3 Provide a brief commentary on the divisionalised profit statements and ROI results shown in slides 1 and 2

(b) The directors of CLUK are planning to expand the operations of the company and together with the divisional managers, have agreed to purchase a new machine that would increase annual production capacity to 50,000,000 cans at Division D1. The purchase of this machine will increase the net assets of Division D1 by $500,000. Assume that there is no impact on unit variable costs or fixed costs resulting from this purchase. Inter-divisional transfers will be priced at opportunity cost. You are required to produce a report to the directors critically discussing the issues and implications of the Transfer Pricing Policy on this investment and divisional profits. You should support your answer with suitable analysis and revised profit statements (these should be included as appendices to your report). Your report should be produced in a Word document containing no more than 1,000 words (+/- 10%).

Paper For Above instruction

Introduction

Cluk’s organizational structure comprises two autonomous divisions, D1 and D2, engaged in manufacturing and selling plastic containers and high-protein drinks, respectively. The divisional performance measurement hinges on metrics such as Return on Investment (ROI) and Residual Income (RI), which influence managerial incentives and decision-making, especially concerning strategic investments like expanding capacity. This paper examines the financial performance of each division based on the provided budget data, assesses the implications of the current transfer pricing policy, and discusses the potential effects of investing in new machinery under the existing transfer pricing constraints.

Division D1's Profit Statement andROI Analysis

Using the given data, a detailed profit statement for Division D1 can be constructed. External sales are projected at a selling price of $130 per 1,000 containers, with variable costs amounting to $0.04 per container. Fixed costs total $2.4 million annually, and the division has a capacity of 40 million containers, with a retail demand of 38 million containers. The division’s total external revenue from container sales is calculated as:

  • Revenue = (Retail demand) x (Price per 1,000 containers) = 38,000,000 / 1,000 x 130 = $4,940,000

The internal sales to Division D2 are at the transfer price, which is based on full cost plus 20%. To compute this, total variable costs per container (assuming actual consumption data or an average) and fixed costs allocated must be considered. The profit statement separates external sales, intra-divisional transfers, and associated costs, showing the contribution margins and resulting divisional profit.

Similarly, the ROI for Division D1 is calculated as:

  • ROI = (Segment Profit) / (Net Assets)

Division D1's net assets are valued at $4 million, and the division's profit is derived from its total contribution minus fixed costs. Using these figures, the ROI can be compared against the target of 25%, highlighting whether the division meets, exceeds, or falls short of the benchmark.

Division D2's Profit Statement andROI Analysis

Division D2’s sales revolve around high-protein drinks sold at $0.50 per container, with variable costs excluding containers at $0.15 per drink. The total variable costs include the container cost acquired from Division D1 at transfer prices. The annual sales volume is 20 million containers. The profit statement accounts for sales revenue, variable costs (including container costs), fixed costs of $1,750,000, and computes the division’s profit and ROI accordingly.

The transfer price determined as full cost plus 20% significantly impacts Division D2’s costs and profitability. The calculated ROI is then assessed against the 25% target, indicating whether Division D2 is incentivized adequately under current transfer pricing policies.

Implications of Transfer Pricing Policy for Investment

The transfer pricing policy set at full cost plus 20% creates potential distortions in divisional profits and performance metrics. When considering expansion, such as the purchase of a new machine that increases capacity to 50 million containers, the key issue is the appropriateness of the transfer pricing mechanism—particularly the use of opportunity costs for intra-divisional transfers from Division D1 to D2.

The adjustment in capacity and net assets ($500,000 increase) substantially influences the division’s profitability calculations and ROI. The use of opportunity cost transfer pricing aligns with maximizing overall corporate profit and promoting divisional efficiency, but it may also lead to suboptimal decisions if divisional managers focus solely on transfer prices rather than overall corporate strategy.

Analysis and Revised Profit Statements

Implementing the new capacity expansion under an opportunity cost transfer pricing policy requires the recalculation of profit statements for each division, considering the additional capacity and assets. The revised statements should reflect the increased production volume, adjusted transfer prices based on marginal or opportunity costs, and the consequent impact on divisional profitability and ROI.

The critical analysis reveals that a shift to opportunity cost as the transfer price better aligns divisional incentives with corporate profitability. It encourages Division D1 to utilize excess capacity efficiently, and Division D2 to value the containers at their true marginal cost, preventing distortions caused by markup over full costs.

Conclusion

Effective performance measurement and strategic investment decisions depend heavily on appropriate transfer pricing policies. The current full cost plus 20% policy may not incentivize optimal capacity utilization, especially when expansion plans are considered. Transitioning to transfer prices based on opportunity costs could enhance divisional decision-making and improve overall firm performance, aligning individual divisional goals with corporate objectives. The revised profit statements based on these principles will provide clearer insights into the benefits and trade-offs associated with capacity expansion, guiding better managerial and investment decisions.

References

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