Question

Phoenix Inc., a cellular communication company, has multiple business units, organized as divisions. Each division’s management is compensated based on the division’s operating income. Division A currently purchases cellular equipment from outside markets and uses it to produce communication systems. Division B produces similar cellular equipment that it sells to outside customers—but not to division A at this time. Division A’s manager approaches division B’s manager with a proposal to buy the equipment from division B. If it produces the cellular equipment that division A desires, division B will incur variable manufacturing costs of $60 per unit.

Relevant Information about Division B

Sells 85,000 units of equipment to outside customers at $130 per unit

Operating capacity is currently 80%; the division can operate at 100%

Variable manufacturing costs are $70 per unit

Variable marketing costs are $8 per unit

Fixed manufacturing costs are $860,000

Income per Unit for Division A (assuming parts purchased externally, not internally from division B)

Sales revenue				$	320
Manufacturing costs:
Cellular equipment		80
Other materials		10
Fixed costs		40
Total manufacturing costs					130
Gross margin					190
Marketing costs:
Variable		35
Fixed		15
Total marketing costs					50
Operating income per unit				$	140

Required:

1. Division A wants to buy 39,000 units from division B at $75 per unit. Determine the contribution margin for each type sale by division B. Should division B accept or reject the proposal? How would your answer differ if (a) division A requires all 39,000 units in the order to be shipped by the same supplier and what would be the net operating loss or gain to division B and the firm as a whole, or (b) division A would accept partial shipment from division B and what would be the benefit from this alternative to division B?

2. What is the range of transfer prices over which the divisional managers might negotiate a final transfer price?

Answer 1

Solution:

Current situation of Department B

	Total $ (85,000 Units)	Per Unit $
Sales	1,10,50,000.00	130.00
Variable Costs
Variable manufacturing cost	59,50,000.00	70.00
Variable marketing costs	6,80,000.00	8.00
Total Variable Costs	66,30,000.00	78.00
Contribution = Sales - Total Variable Costs	44,20,000.00	52.00
Less: Fixed Costs	8,60,000.00
Profit	35,60,000.00

Current production = 85,000 units (80% Capacity)

Therefore, 100% capacity = 106,250 units

Solution 1a) Calculation of net operating loss or gain to division B and the firm as a whole If division A requires all 39,000 units in the order to be shipped by the same supplier.

As the 100% capacity is 106,250 units and the demand from Division A is 39,000 units, number of units to be sold to the outside market

= 106,250 – 39,000 = 67,250 units

	Outside Sales		Sales to Division A		Total
	Total $ (67,250 Units)	Per Unit $	Total $ (39,000 Units)	Per Unit $	106,250 units
Sales	87,42,500.00	130.00	29,25,000.00	75.00	1,16,67,500.00
Variable Costs
Variable manufacturing cost	47,07,500.00	70.00	23,40,000.00	60.00	70,47,500.00
Variable marketing costs	5,38,000.00	8.00	-	-	5,38,000.00
Total Variable Costs	52,45,500.00	78.00	23,40,000.00	60.00	75,85,500.00
Contribution = Sales - Total Variable Costs	34,97,000.00	52.00	5,85,000.00	15.00	40,82,000.00
Less: Fixed Costs	8,60,000.00		-		8,60,000.00
Profit	26,37,000.00		5,85,000.00		32,22,000.00

In this case, Division B is making a loss of $338,000 ($35,60,000 - $32,22,000)

Calculation of Total Profit or Loss to the firm:

	$
Profit to Division B	(3,38,000.00)
Profit to Division A = ($80 -$70) x 39,000 units	3,90,000.00
Net Profit or Loss to the firm	52,000.00

  

Solution 1B) Calculation of net operating loss or gain to division B and the firm as a whole If division A would accept partial shipment from division B.

In this case, the division B should sell 85,000 units to the outside market and 21,250 units to Division A.

	Outside Sales		Sales to Division A		Total
	Total $ (85,000 Units)	Per Unit $	Total $ (21,250 Units)	Per Unit $	106,250 units
Sales	1,10,50,000.00	130.00	15,93,750.00	75.00	1,26,43,750.00
Variable Costs
Variable manufacturing cost	59,50,000.00	70.00	12,75,000.00	60.00	72,25,000.00
Variable marketing costs	6,80,000.00	8.00	-	-	6,80,000.00
Total Variable Costs	66,30,000.00	78.00	12,75,000.00	60.00	79,05,000.00
Contribution = Sales - Total Variable Costs	44,20,000.00	52.00	3,18,750.00	15.00	47,38,750.00
Less: Fixed Costs	8,60,000.00		-		8,60,000.00
Profit	35,60,000.00		3,18,750.00		38,78,750.00

In this case, Division B is making a profit of $318,750 ($3,878,750 - $3,560,000)

Calculation of Total Profit or Loss to the firm:

	$
Profit to Division B	3,18,750.00
Profit to Division A = ($80 -$70) x 21,250 units	2,12,500.00
Net Profit or Loss to the firm	5,31,250.00

Therefore, it is recommended that the Division B should go for partial transfer to Division A, as it will be profitable for Division B and the firm as a whole.

Solution 2) Range of transfer would be between the variable manufacturing cost for Division B manufacturing the units for division A i.e.$60 and market price at which the product is available for Division A in the outside market i.e. $80