Reno Company is a decentralized company that has two divisions, Division A and D
ID: 2571904 • Letter: R
Question
Reno Company is a decentralized company that has two divisions, Division A and Division B. Division A has the capacity to manufacture 24,000 units of a product that could be used by Division B. Division A currently is selling 16,000 units of the product to customers outside the company, incurring the following costs: variable costs of $7 per unit and total fixed costs of $48,000. The selling price to these customers is $16 per unit. Division B needs 4,000 units of the product that Division A makes. It currently is purchasing the units from an outside supplier at a price of $15 each. Division B offers to purchase the units from Division A at a price of $12; the managers of Division A say the price must be at least $14. The managers of the two divisions appear to have reached a stalemate, which threatens to prevent the transfer from occurring within the company. Required: 1) Is it in the best interest of Reno Company for Division B to purchase the units from Division A? Show quantitative support for your answer. 2) If the transfer is in the best interest of the company as a whole, should the top managers of Reno Company order the division managers to come to terms? How might the top management of Reno handle the situation other than by ordering the division managers to make the transfer?
Explanation / Answer
1)
Division A has the capacity to produce 24000 units and it is now producing and selling 16000 units to the outside customers. Assuming that the maximum demand, at present, from the market outside the company is only 16000 units, we can say that Division A has a spare capacity to produce another 24000 – 16000 = 8000 units. As there is spare capacity and division B requires only 4000 units, it is in the best interest of the company that division B purchases the product from Division A. Moreover, contribution per unit from selling the product to outside market = $16 - $7 = $9 per unit. So total contribution = 16000 x $9 = $144000 which gives a profit to division A = $144000 - $48000 = $96000. That means the fixed cost of company has been completely recovered by the sale of these 16000 units to the outside customers.
If division B purchases the product from division A at $12 per unit, the profit of the overall company will increase which could be illustrated as follows:
Contribution per unit of 4000 units = $12 - $7 = $5 per unit
Incremental contribution from 4000 units to Division A = 4000 x $5 = $20000
As fixed cost has already been recovered,
Incremental profit to division A = $20000
For division B:
Incremental profit if 4000 units purchased from A
= savings in purchase x 4000 units
= ($15 - $12) x 4000
= $12000
Overall the profit of the company will increase by
$20000 + $12000 = $32000
Therefore it is in the best interest of the company that division B purchases the product from Division A as this will utilize the spare capacity of the company as a whole.
2)
The top managers of the company should ask the divisional managers to come to terms. If the divisions are acting as responsibility centre’s (as they are decentralized divisions), then the divisional managers will be responsible for the profit earned by the divisions and in that case the divisional managers may enter into a stiff negotiating procedure regarding the transfer price. If the transfer price is set at $12 per unit division B will earn an additional income of $12000 and division A $20000. But if it is set at $14 per unit division B will earn an additional income of ($15-$14) x 4000 = $4000 and division A ($14-$7) x 4000 = $28000. Whatever ay be the transfer price, the company stands to gain $32000 overall.
To trap this opportunity of increasing the overall profit the top managers can issue a direction to the divisional managers that instead of acting as responsibility centers they will have to act to increase the overall profit of the organization. To do this the company may centralize the entire operations of divisions A and B. In that case, division A can simply supply the 4000 units at a $ 7 per unit to division B that is at the marginal cost of the product. However if the external demand of the product increases then division A can sale the same to the outside customers if the price of the product in the external market is higher than the marginal cost of the product.