Question

InterGlobal Industries is a diversified corporation with separate operating divisions. Each division’s performance is evaluated on the basis of profit and return on investment.

The Air Comfort Division manufactures and sells air-conditioner units. The coming year’s budgeted income statement, which follows, is based upon a sales volume of 15,000 units.

AIR COMFORT DIVISION
Budgeted Income Statement
(In thousands)
	Per Unit					Total
Sales revenue		$	400				$	6,000
Manufacturing costs:
Compressor		$	70				$	1,050
Other direct material			37					555
Direct labor			30					450
Variable overhead			45					675
Fixed overhead			32					480
Total manufacturing costs		$	214				$	3,210
Gross margin		$	186				$	2,790
Operating expenses:
Variable selling		$	18				$	270
Fixed selling			19					285
Fixed administrative			38					570
Total operating expenses		$	75				$	1,125
Net income before taxes		$	111				$	1,665

Air Comfort’s division manager believes sales can be increased if the price of the air-conditioners is reduced. A market research study by an independent firm indicates that a 5 percent reduction in the selling price would increase sales volume 16 percent, or 2,400 units. The division has sufficient production capacity to manage this increased volume with no increase in fixed costs.

The Air Comfort Division uses a compressor in its units, which it purchases from an outside supplier at a cost of $70 per compressor. The Air Comfort Division manager has asked the manager of the Compressor Division about selling compressor units to Air Comfort. The Compressor Division currently manufactures and sells a unit to outside firms that is similar to the unit used by the Air Comfort Division. The specifications of the Air Comfort Division compressor are slightly different, which would reduce the Compressor Division’s direct material cost by $1.50 per unit. In addition, the Compressor Division would not incur any variable selling costs in the units sold to the Air Comfort Division. The manager of the Air Comfort Division wants all of the compressors it uses to come from one supplier and has offered to pay $50 for each compressor unit.

The Compressor Division has the capacity to produce 75,000 units. Its budgeted income statement for the coming year, which follows, is based on a sales volume of 64,000 units without considering Air Comfort’s proposal.

COMPRESSOR DIVISION
Budgeted Income Statement
(In thousands)
	Per Unit					Total
Sales revenue		$	100				$	6,400
Manufacturing costs:
Direct material		$	12				$	768
Direct labor			8					512
Variable overhead			10					640
Fixed overhead			11					704
Total manufacturing costs		$	41				$	2,624
Gross margin		$	59				$	3,776
Operating expenses:
Variable selling		$	6				$	384
Fixed selling			4					256
Fixed administrative			7					448
Total operating expenses		$	17				$	1,088
Net income before taxes		$	42				$	2,688

Required:

1. 1-a. Calculate the increase/decrease in net income before taxes for Continental Industries assuming the Air Comfort Division institutes the 5 percent price reduction on its air-conditioner units even if it cannot acquire the compressors internally for $50 each.

2. 1-b. Should the Air Comfort Division institute the 5 percent price reduction?

3. 2. Independently of your answer to Required 1-a, assume the Air Comfort Division needs 17,400 units. Calculate the increase/decrease in net income before taxes for the Compressor Division if it supplies the 17,400 compressor units for $50 each.

4. 3. Independently of your answer to Required 1-a, assume the Air Comfort Division needs 17,400 units. Calculate the increase/decrease in net income before taxes for Continental Industries if the Compressor Division supplies the 17,400 compressor units for $50 each.

Answer 1