The Canadian Instruments Company (CIC) uses a decentralized form of organizational structure and considers each of its divisions as an investment center. The Toronto Division (TD) is currently selling 15,000 air filters annually, although it has sufficient productive capacity to produce 21,000 units per year. Variable manufacturing costs amount to $21 per unit, while the total fixed costs are $90,000. The 15,000 air filters are sold to outside customers at $40 per unit.
The Montreal Division (MD), also a part of CIC, has indicated that it would like to buy 1,500 air filters from TD, but only at a price of $37, since this is the price MD is currently paying to an outside supplier for a similar air filter. The company has a cost of capital of 7%.
a. What is the unit contribution margin for TD’s sales to outsiders? What is the break-even point in units and sales dollars?
b. Will the new order push TD outside its relevant range? Why or why not?
c. What is the pre-tax effect on CIC’s income if MD buys the 1,500 air filters internally from TD?
d. What is the minimum price that TD should be willing to accept for these 1,500 air filters?
e. What is the maximum price that MD should be willing to pay for these 1,500 air filters?
f. What qualitative factors should be considered in this type of decision, above and beyond any transfer price considerations?
g. Suppose that TD is currently producing and selling 21,000 air filters annually to outside customers. What would be the effect on overall CIC income if TD was required by executive management to sell 1,500 air filters to MD at the $37 per unit price?
h. For this part only, assume that TD is currently earning annual operating income of $36,000, and TD’s average invested capital is $300,000. The division manager has an opportunity to invest in a proposal that will require an additional investment of $20,000 and will increase annual operating income by $2,000. What is the impact of this project on TD’s overall ROI?