4. The West Midlands Engineering Corporation manufactures components for the automotive industry. It has two operating divisions one based in Wolverhampton and one in Birmingham. The Wolverhampton division produces sheet metal components which it sells to the Birmingham division. The Birmingham division uses one unit of the sheet metal, for each component made, which it then processes and sells to outside customers. The Wolverhampton division also sells the sheet metal to outside customers. There is no scope for Wolverhampton to increase its external sales. The following budgeted data is available for the two divisions for the financial year ending September 2021: Wolverhampton Birmingham Division Division Sheet Metal Component External Selling Price per unit 25 32 Direct material cost per unit 8 3 Direct labour cost per unit 5 3 Annual divisional fixed production overheads 2,500,000 875,000 Annual divisional fixed administrative overheads 1,000,000 375.000 Variable selling overheads per unit 1.75 1.75 Annual production capacity 1,250,000 units 700,000 units Sales to outside customers 900,000 units 350,000 units Internal sales 350,000 units The transfer price between the Wolverhampton and the Birmingham divisions for the sheet metal is set at Wolverhampton's full cost plus a 25% profit mark-up. In arriving at the full cost for the purposes of calculating the transfer price, both fixed production and administrative overheads are absorbed on the basis of the annual production capacity in terms of units. Variable selling overhead costs are not incurred on internal sales and are therefore excluded when calculating the transfer price. The management of the West Midlands Engineering Corporation measures divisional performance on the basis of both Return on Investment and Residual Income. Return on Investment is measured as divisional net income divided by divisional net assets at the end of the period. The company's target return on investment has been set for the past four years at 12%. The company's Residual Income uses the cost of capital calculated as 12% of the value of the divisional net assets at the end of the period. The values of divisional assets and liabilities for the year ending March 2020 are shown below: Wolverhampton Division Birmingham Division '000 '000 Machinery 18,200 1,000 Inventories 6,200 Trade receivables 2,500 1,000 Cash at Bank 1,300 500 Trade payables 900 500 2,000 Question continues on next page 4. (Continued) Required: a) Based on the existing transfer pricing policy, calculate the budgeted divisional Net Income, Return on Investment and Residual Income for each division for the year ended September 2021. Also calculate the total company Net Income for that year. (4 marks) b) Comment on the budgeted performance of the two divisions on the basis of the financial calculations in part (a). (2 marks) c) The manager of the Birmingham division has not been happy with the performance of this division over the past three years and given the budget projections, plans to make changes for the year ending September 2021. The Birmingham division has recruited a new Purchasing Manager who can source the sheet metal from an alternative supplier for 17 per unit. The supplier could meet all Birmingham Division's demand. This sheet metal is slightly inferior to the product supplied by Wolverhampton Division but is acceptable for production of the expected standard of component. In addition, the sales director of the Birmingham division believes that some of the cost savings can be passed on to the customer and recommends reducing the selling price of each component to 30 per unit. This would lead to sales of 550,000 units per annum. Hearing these plans from the Birmingham division, the Wolverhampton division decides to reduce the transfer price to 17. It finds that it could manufacture the standard of sheet metal required by Birmingham division with a saving on material costs of 0.40 for each sheet. Their main product for external sales will remain at the existing standard so there will be no material cost savings on that product. They expect external sales to remain the same and wish to retain these customers. Using the information provided above, describe the two alternatives available to the Wolverhampton Division and calculate for each alternative, the Net Income of the company as a whole and of each division and the Return on Investment and Residual Income for each division. (6 marks) d) Comment on the results of these alternatives. (3 marks) e) Identify the transfer price method and decision making rules which appear to exist in this company and discuss whether different methods of transfer pricing or company rules should be adopted. (5 marks) 4. The West Midlands Engineering Corporation manufactures components for the automotive industry. It has two operating divisions one based in Wolverhampton and one in Birmingham. The Wolverhampton division produces sheet metal components which it sells to the Birmingham division. The Birmingham division uses one unit of the sheet metal, for each component made, which it then processes and sells to outside customers. The Wolverhampton division also sells the sheet metal to outside customers. There is no scope for Wolverhampton to increase its external sales. The following budgeted data is available for the two divisions for the financial year ending September 2021: Wolverhampton Birmingham Division Division Sheet Metal Component External Selling Price per unit 25 32 Direct material cost per unit 8 3 Direct labour cost per unit 5 3 Annual divisional fixed production overheads 2,500,000 875,000 Annual divisional fixed administrative overheads 1,000,000 375.000 Variable selling overheads per unit 1.75 1.75 Annual production capacity 1,250,000 units 700,000 units Sales to outside customers 900,000 units 350,000 units Internal sales 350,000 units The transfer price between the Wolverhampton and the Birmingham divisions for the sheet metal is set at Wolverhampton's full cost plus a 25% profit mark-up. In arriving at the full cost for the purposes of calculating the transfer price, both fixed production and administrative overheads are absorbed on the basis of the annual production capacity in terms of units. Variable selling overhead costs are not incurred on internal sales and are therefore excluded when calculating the transfer price. The management of the West Midlands Engineering Corporation measures divisional performance on the basis of both Return on Investment and Residual Income. Return on Investment is measured as divisional net income divided by divisional net assets at the end of the period. The company's target return on investment has been set for the past four years at 12%. The company's Residual Income uses the cost of capital calculated as 12% of the value of the divisional net assets at the end of the period. The values of divisional assets and liabilities for the year ending March 2020 are shown below: Wolverhampton Division Birmingham Division '000 '000 Machinery 18,200 1,000 Inventories 6,200 Trade receivables 2,500 1,000 Cash at Bank 1,300 500 Trade payables 900 500 2,000 Question continues on next page 4. (Continued) Required: a) Based on the existing transfer pricing policy, calculate the budgeted divisional Net Income, Return on Investment and Residual Income for each division for the year ended September 2021. Also calculate the total company Net Income for that year. (4 marks) b) Comment on the budgeted performance of the two divisions on the basis of the financial calculations in part (a). (2 marks) c) The manager of the Birmingham division has not been happy with the performance of this division over the past three years and given the budget projections, plans to make changes for the year ending September 2021. The Birmingham division has recruited a new Purchasing Manager who can source the sheet metal from an alternative supplier for 17 per unit. The supplier could meet all Birmingham Division's demand. This sheet metal is slightly inferior to the product supplied by Wolverhampton Division but is acceptable for production of the expected standard of component. In addition, the sales director of the Birmingham division believes that some of the cost savings can be passed on to the customer and recommends reducing the selling price of each component to 30 per unit. This would lead to sales of 550,000 units per annum. Hearing these plans from the Birmingham division, the Wolverhampton division decides to reduce the transfer price to 17. It finds that it could manufacture the standard of sheet metal required by Birmingham division with a saving on material costs of 0.40 for each sheet. Their main product for external sales will remain at the existing standard so there will be no material cost savings on that product. They expect external sales to remain the same and wish to retain these customers. Using the information provided above, describe the two alternatives available to the Wolverhampton Division and calculate for each alternative, the Net Income of the company as a whole and of each division and the Return on Investment and Residual Income for each division. (6 marks) d) Comment on the results of these alternatives. (3 marks) e) Identify the transfer price method and decision making rules which appear to exist in this company and discuss whether different methods of transfer pricing or company rules should be adopted