HK Coffee Machines Co. (JHK) manufactures coffee makers for use in bars and cafes. It has been successful over the last five years and has built and maintained a loyal customer base by making a high-quality machine backed by a three-year warranty. The warranty states that JHK will recover and repair any machine that breaks down in the warranty period at no cost. Additionally, JHK always maintains sufficient spare parts to be able to quote for a repair of any of its machines made within the previous ten years.JHK is structured into two divisions: manufacturing/sales (M/S) and service. The board is now considering ways to improve coordination of the activities of the divisions for the benefit of the company as a whole.The company?s mission is to maximize shareholder wealth.Currently, the board use total shareholder return (TSR) as an overall corporate measure of performance and return on investment (ROI) as its main relative measure of performance between the two divisions. The board?s main concern is that the divisional managers? performance is not being properly assessed by the divisional performance measure used. It now wants to consider other measures of divisional performance. Residual income (Rl) and economic value added (EVA^TM) have been suggested.A colleague has collected the following data which will allow calculation of ROI, Rl and EVA^TM

Operating costs include:

All operating costs are tax deductible.In addition to the divisional performance measures, the board wants to consider the position of the service division.The standard costs within the service division are as follows:

..............................................................................$Labour (per hour) ...............................................18Variable divisional overhead (per hour) .............12Fixed divisional overhead (per hour) .................25

Overheads are allocated by work hoursCurrently, the service division does two types of work. There are repairs that are covered by JHK?s warranty and there are repairs done outside warranty at the customer?s request. The service division is paid by the customer for the out-of-warranty repairs while the repairs under warranty generate an annual fee of $10m, which is a recharge from the M/S division. The company sells 440 000 units per year and in the past, 9 percent of these have needed a repair within the three-year warranty. Parts are charged by the M/S division to the service division at cost and average $75 per repair. A repair takes two hours, on average, to complete.The board is considering amending this existing $10m internal recharge agreement between M/S and service, There has been some discussion of tailoring one of the two transfer pricing approaches (market price or cost plus) to meet the company?s objectives.Although the service division has the capacity to cover all of the existing work available, it could outsource the warranty service work, as it is usually straightforward. It would retain the out-of-warranty service work as this is a higher margin business. It would then begin looking for other opportunities to earn revenue using its engineering experience. A local engineering firm has quoted a flat price of $200 per warranty service repair provided that it obtains a contract for all of the warranty repairs from JHK.

Finally, the board is also considering a change to the information systems at JHK, The existing systems are based in the individual functions (production, sales, service, finance and human resources). The board is considering the implementation of a new system based on an integrated, single database that would be accessible at any of the company?s five sites. The company network would be upgraded to allow real-time input and update of the database. The database would support a detailed management information system and a high-level executive information system.

Required:Write a report to the finance director to:(a) Evaluate the divisional performance at JHK and critically discuss the proposed measures of divisional performance.(b) Outline the criteria for designing a transfer pricing system and evaluate the two methods discussed for calculating the transfer price between the service and M/S divisions. (Perform appropriate calculations.)

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Manufacturing/ sales $m Service $m Revenue 880 17.0 Operating costs 494 11.0 Operating profit Apportioned head office costs Profit before tax Capital employed The notional cost of capital used is The current cost of debt is The tax rate is 386 6.0 85 1.0 301 5.0 1294 38.0 9% pa 5.5% 30%