Boots Company has two divisions. Land Division, which has operating assets of $8

Question

Boots Company has two divisions. Land Division, which has operating assets of $80,000,000 produces and sells 900,000 units of a product at a market price of $140 per unit. Variable costs total $40 per unit. The division also assigns $70 of fixed costs to each unit based on total capacity of 1,000,000 units. Sea Division wants to purchase 200,000 units from Land. However, it is only willing to pay $80 per unit because it has an opportunity to accept a special order at a reduced price. The order is economically justifiable only if Sea Division can acquire Land Division’s output at a reduced price. Boots Company’s cost of capital is 15%. Required. a. What is the residual income for Land Division without the transfer to Sea Division? b. What is Land Division’s residual income if it transfers 200,000 units to Sea Division at $80 each? c. What is the minimum transfer price for the 200,000-unit order that Land would accept if it were willing to maintain the same residual income with the transfer as it would accept by selling its 900,000 units to the outside market?

Explanation / Answer

Calculation of the Residual Income a Sales 900000 Units Sales 140 126000000 Variable Costs 40 36000000 Contribution 90000000 Fixed Cost 70000000 Net Operating Income 20000000 Minimum Income 12000000 (80000000*15%) Residual Income 8000000 ( 20000000-12000000) b Sells 200000 to Sea division 1000000 units Sales 128000000 (800000*140+200000*80) Variable Costs 40 40000000 Contribution 88000000 Fixed Cost 70000000 Net Operating Income 18000000 Minimum Income 12000000 (80000000*15%) Residual Income 6000000 c. If same Reisdual Income is required Residual Income 8000000 Net Operating 20000000 Fixed Cost 70000000 Contribution 90000000 Variable Cost 40000000 Sales 130000000 For 800000 units 140*800000 112000000 Balance 18000000 (130000000-112000000) Transfer Price 90 The minimum transfer price should be $ 90

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