Question

Calvin Machinery Company manufactures heavy-duty equipment used in foundries, mining operations, and similar operations. The company is very decentralized, with various division managers having control over capital investments and most production decisions. The Cylinder Division fabricates a component which is used by the Press Division in its production of metal presses. The Cylinder Division has been selling to the Press Division at a price of $3,000 per unit. Because of a cost increase, the Cylinder Division wants to increase its price to $3,200, even though the Press Division can still purchase an equivalent component externally for $3,000. The following information has been gathered regarding this issue:

Press Division’s annual purchases		100	units
Cylinder Division’s variable costs	$	2,400	per unit
Cylinder Division’s fixed costs	$	600	per unit

Required:

a. If the Press Division buys its units externally, the Cylinder Division will have idle capacity for which there are no alternative uses. Will the company as whole benefit if the Press Division purchases its units externally for $3,000 per unit?
b. If the Press Division buys its units externally, the Cylinder Division will have idle capacity which can be used to generate a positive cash flow of $40,000. Will the company as whole benefit if the Press Division purchases its units externally for $3,000 per unit?
c. Refer to (b). Will your answer change if the price at which the Press Division can buy externally decreases to $2,700 per unit? Support your answer.

Answer 1

Solution a:

As Cylinder division is having spare capacity and variable cost per unit is only $2,400 per unit, therefore company as a whole will not benefit if the Press Division purchases its units externally for $3,000 per unit. Company as a whole will incur loss of = ($3,000 - $2,400) * 100 = $60,000

Solution b:

If press division buys its units externally and cylinder division can use idle capacity to generate positive cash flow of $40,000, then benefit to the company as a whole =Positive cash flow from idle capacity - Extra cost of buying

= $40,000 - $60,000 = ($20,000)

Therefore company will not benefit if the press division purchases its units externally for $3,000 per unit.

Solution c:

If press division buys its units externally and cylinder division can use idle capacity to generate positive cash flow of $40,000, then benefit to the company as a whole =Positive cash flow from idle capacity - Extra cost of buying

= $40,000 - 100 * ($2,700 - $2,400) = $10,000

Therefore company will benefit if the press division purchases its units externally for $2,700 per unit. Total benefit to the company as a whole is $10,000.