Maja and Mina are both divisions of Arbor Group. Both divisions trade on the open market but Maja also provides almost a quarter of its production output to Mina. Maja believes that Mina pays less than Maja could sell the product for on the open market.

As evidence, Maja has calculated its cost of sales as 40% of external sales and 60% of intercompany sales.

The operating results of the company are shown below. The divisional managers are rewarded on the basis of achieving an ROI, provided that it is greater than the cost of capital of 12%. The higher the ROI over that base, the higher the divisional manager’s performance bonus.

The management team of Mina has argued that it has been unfairly treated due to the transfer price from Maja. It has recalculated its performance (and that of Maja) based on a reduction in the transfer price by 20%. The revised figures produced by Mina’ financial controller are shown below:

a. What are the strengths and weaknesses of Mina’s argument?

b. What position would you take if you were on the management team of Maja?

c. How should Arbor Group resolve this issue?

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Maja Mina Total Total assets $3,500,000 $6,500,000 $10,000,000 Sales revenue 1,200,000 2,400,000 3,600,000 Intercompany sales 350,000 -350,000 0 Variable costs -690,000 -720,000 -1,400,000 Gross profit 860,000 1,330,000 2,190,000 Fixed selling & admin expense -250,000 -300,000 -550,000 Operating profit before interest 610,000 1,030,000 1,640,000 Gross margin 71.7% 55.4% 60.8% Return on investment 17.4% 15.8% 16.4% Cost of capital @ 12% 420,000 780,000 1,200,000 Residual income 190,000 250,000 440,000