In: Accounting
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.
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.