Magenta Company has a Components Division which currently manufactures 120,000 units of Part AAM but has a

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Question:

Magenta Company has a Components Division which currently manufactures 120,000 units of Part AAM but has a capacity to produce 180,000 units. The unit variable cost of Part AAM is $22, and the total fixed costs are $720,000 or $6 per unit based on current production.

As its sales has been down in the current year, Jasper, the manager of the Components Division approached Kelvin, the manager of the Production Division to buy some of its excess capacity. Jasper wants to charge the Production Division at market price otherwise his profits will fall from last year’s levels. He told Kelvin that the divisions are under strict orders to maximise profitability.

Kelvin asked for a price break saying that both divisions are part of the same company and thus should help each other. He offers to buy 40,000 units of Part AAM at $21 per unit from the Components Division. It has the option to buy from an external supplier for $26 per unit.

Jasper refuses to budge as the market price is $26 per unit. Kelvin then argues that the order should be accepted as Jasper can lower his fixed costs per unit from $6 to $4.50 due to the increase in output. This decrease of $1.50 in fixed costs per unit will more than offset the $1 difference between the unit variable cost and the transfer price.

Required:

a. If you were the Components Division manager, would you accept the Production Division manager’s argument? Why or why not? Assume that these 120,000 units currently being produced, sell for $28 per unit in the external market. (3 marks)
b. Determine the minimum and maximum transfer price. Should an internal transfer take place? Why or why not? (3 marks)
c. Determine the impact on the profit of each division and the company if an internal transfer takes place. (3 marks)
d. Explain whether both managers are justified in their arguments. How can the Components Division manager be persuaded to do the internal transfer? (6 marks)