Morgan Montgomery is the chief executive officer of a biotechnology firm that specializes in developing disease- and drought-resistant strains of wheat, corn, and soybeans. The firm is organized into three divisions, with separate staff, facilities, and equipment. However, because the underlying science is similar, all three divisions use the same technology, albeit with differing intensity. Morgan's firm currently is debating acquiring a DNA sequencing machine. The following are excerpts from each of the divisions regarding this issue.
Wheat Division: We currently sequence about a million base pairs each year and pay an outside vendor $0.45 per base pair. We looked into purchasing our own machine. We found a machine that has enough capacity for our needs - its annual fixed costs would be $400,000 and, as per industry standards, the variable costs would be $0.10 per base pair, regardless of scale. Based on these numbers, we plan to continue getting the sequencing done by the outside vendor.
Corn Division: We are in the same boat, although our volume is only 500,000 base pairs a year. We can get a small machine, but it is not cost-effective. Considering fixed and variable costs, it will cost us close to $0.55 per pair if we buy the machine - thus, it doesn't make sense for us to buy a machine when we can get the work done by the outside vendor $0.45 per pair. When our volume increases, as we anticipate, we may revisit this issue.
Soybean Division: We are probably the least intensive users of sequencing. We only sequence 100,000 base pairs in a year, and it is simply not viable for us to get a machine. The smallest machine will give us five times the capacity we need - accordingly, we also plan to continue using the outside vendor.
Morgan is looking into buying a machine that will satisfy the needs of all three divisions. She has found a machine that has a capacity of 2 million base pairs a year. This machine will lead to annual fixed costs of $550,000 and a variable cost of $0.10 per base pair sequenced.
Required:
a. Calculate the change in the firm's profit if Morgan decides to buy the machine and has all sequencing done internally.
b. What other factors should Morgan consider in her decision?
c. Suppose Morgan acquires the machine and instructs all divisions to do their sequencing in-house. How much cost should be allocated to each division?
d. The head of the Soybean Division argues that none of the fixed cost should be allocated to her division. She argues that the firm would have likely bought the machine whether her division wanted it or not, and that she is merely using the capacity that would otherwise go to waste. Evaluate the merit of this argument.