Question Tag: Divisional Profitability

Naijax Group Limited has been in operation since 1980, playing a leading role in the automobile industry.

Division “X,” which is part of the group, manufactures only “265 by 16’’ Rim tyre, which it sells to external customers and also to Division “Y,” another member of the group. Naijax Group’s policy is that:

• Divisions have the freedom to set transfer prices and choose their suppliers.
• It uses Residual Income (RI) for performance appraisals.
• The group’s cost of capital is 12% per annum.

The two divisions’ operating data are as follows:

Division Y has found two other companies willing to supply tyres:

• Adex Limited could supply at N28,000 per tyre, but only for annual orders in excess of 50,000 tyres.
• Banaxa Limited could supply at N33,000 per tyre for any quantity ordered.

Required:

(a) If Division Y provisionally requests a quotation for 60,000 tyres from Division X for the coming year:

i. Determine the transfer price per tyre that Division X should quote in order to meet its residual income target. (9 Marks)

ii. Calculate the TWO prices that Division X would have to quote to Division Y if it becomes the group’s policy to quote transfer prices based on opportunity costs. (2 Marks)

(b) Evaluate the impact of the group’s current and proposed policies on the profits of Divisions X and Y and on group profit. (4 Marks)

c. Assume that Divisions X and Y are based in different countries and consequently pay taxes at different rates: Division X at 55% and Division Y at 25%. If Division X has now quoted a transfer price of N30,000 per tyre for 60,000 tyres, you are required to determine whether it is better for the group if Division Y purchases
60,000 tyres from Division X or from Adex Limited. (15 Marks)