Problem
Mary is the vice president of Conely division and went to her office to crunch numbers on the new express charger project. At a price of $10 per unit, the marketing department estimates demand for the product at 40,000 units. The division will need to purchase a new machine for $100,000 to produce the charger. Mary also estimates that the division will incur an additional $140,000 in fixed costs that are directly attributable to the charger. One component of the charger is currently produced by the company's Amber division at a variable cost of $3 per unit. The component is sold to outside customers for $5 per unit. Mary met with the vice president of Amber division and discussed the possibility of Amber division supplying the needed component. The vice president said that they can provide the component at the market price of $5 per unit and that they have the capacity to make 150,000 components but are only producing 135,000 for external customers. The Conely division currently earns $250,000 on 2.5 million in sales revenue. The asset base of the division is $1,250,000. Mary is concerned that the offer of $5 per unit may boost product costs too high and reduce the return on investment.
a. What is Conely division's current return on investment?
b. Given the projected demand for the charger and the current cost estimates for the product, what is the maximum total variable cost that Mary can incur and still maintain the division's ROI? What would be the resulting contribution margin per unit for the charger?
c. What is the minimum transfer price that the Amber division should be willing to charge the Conely division for the 40, 000 components it needs to produce the charger?
d. Regardless of the answer of part (b), assume that Mary has determined that the maximum acceptable variable cost per unit is $6 and that all but $2 of that cost will be attributable to the component transferred from the Amber Division. Will Mary accept Amber division's minimum transfer price?
e. Suppose the president of the company has decided to evaluate divisional vice presidents based on residual income rather than ROI. If he requires a 14% minimum rate of return, will Mary be able to accept the Amber division's minimum transfer price?
f. What do you recommend?