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 $4,600 and it averages machine time of 4,000 hours annually. The new server leases for an annual rate of $8,200. Because the new server is a faster machine, Health Services can complete its current requirements in only 2,800 hours. The work for Optics is estimated to be 1,600 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 $36,000 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 per hour of machine usage. The current lease contract can be canceled at no cost if Health Services leases a more expensive machine.

Required:

a. Assume that no outside market exists for this service and that Health Services would have excess capacity on the new server. What is the optimal transfer price rule Health Services should use to charge Optics?

b. Suppose Optics uses 1,600 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 240 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

b)
Average cost - $22 per hour

Explanation of b.
Fixed fee                                                        $25,200
Variable cost     (1200 hours × $1)              $1200
Total transfer cost                                      $26,400
Average hourly cost ($26400÷1200hrs)     $22 per hour

C)
Average cost - 211 per hour

Explanation of c.
Fixed fee                                                      $25,200
Variable cost    (120 hours ×$1)                 $120
Total transfer cost                                      $25,320
Average hourly cost($25,320÷120hrs)      $211 per hour

a)
Total fixed fee - $25,200
Variable cost - 1 per hour

Explanation of a.
Fixed:
Incremental lease cost ($5400-$3400)           $2,000
Incremental support cost                                  $24,000    
                                                                                $26,000
Less: maintenance saving (3000-2200)×$1        ($800)                                   
Total fixed fee                                                      $25,200
Variable cost            (maintenance )                  $1 per hour