Question

CHS is a large multidivision firm. One division, Health Services, is well known inside CHS for its efficient information technology (IT). A smaller division, Optics, has approached Health Services with a proposal that it provide IT support in the form of machine time for some of Optics’s billing and administrative work.

After an analysis of the demands that Optics would place on the system, the IT manager of Health Services notes that Health Services would have to lease a new server because of the additional load. The lease rates for the current server are a fixed annual lease of $3,210 and it averages machine time of 2,820 hours annually. The new server leases for an annual rate of $5,110. Because the new server is a faster machine, Health Services can complete its current requirements in only 2,050 hours. The work for Optics is estimated to be 1,040 hours.

In addition to leasing a new server, there are two other changes Health Services would have to make in IT. First, it will have to upgrade its server support position. The IT manager estimates that it will cost an additional $21,700 per year to get an individual with the necessary advanced training. In addition, Health Services has a contract for service from the machine vendor. The support contract is a fixed-price contract of $1.00 per hour of machine usage. The current lease contract can be canceled at no cost if Health Services leases a more expensive machine.

Suppose Health Services could sell time on the machine to other companies in the area on a per-hour basis. Further, it can sell all the time available for $40 per hour.

What is the optimal transfer price rule Health Services should use to charge Optics?

b. Suppose Optics uses 1,040 hours on the new machine. What is the average cost per hour Optics would pay using the rule you developed in requirement (a)?

c. Suppose Optics uses 104 hours on the new machine. What is the average cost per hour Optics would pay using the rule you developed in requirement (a)?

Answer 1

a)

When an intermediate market exists, the optimal transfer price is the market price.

Transfer Price = Market Price = $40 per hour

b)

Average cost per hour Optics would be equal to transfer price $40.

It doesn't matter how many hours are used if transfer price is based on market price not on variable cost.

c)

Average cost per hour Optics would be equal to transfer price $40.

It doesn't matter how many hours are used if transfer price is based on market price not on variable cost.