Problem 20 - Accounting

Question

Materials used by the Truck Division of Monumental Motors are currently purchased from outside suppliers at a cost of \(\$ 260\) per unit. However, the same materials are available from the Component Division. The Component Division has unused capacity and can produce the materials needed by the Truck Division at a variable cost of \(\$ 190\) per unit. a. If a transfer price of \(\$ 210\) per unit is established and 50,000 units of materials are transferred, with no reduction in the Component Division's current sales, how much would Monumental Motors' total income from operations increase? b. How much would the Truck Division's income from operations increase? c. How much would the Component Division's income from operations increase?

Step-by-Step Solution

Answer

a. $3,500,000 increase; b. $2,500,000 increase; c. $1,000,000 increase.

Step 1: Calculate Cost Savings for Truck Division

The Truck Division is purchasing materials at \(\\(260\) per unit from outside suppliers but can get them for \(\\)210\) from the Component Division. The savings per unit is \(\\(260 - \\)210 = \\(50\). For 50,000 units, the total savings is \(50,000 \times \\)50 = \$2,500,000\).

Step 2: Calculate Income Increase for Truck Division

The increase in income for the Truck Division is simply the total savings calculated in Step 1, which is \(\$2,500,000\).

Step 3: Calculate Income for Component Division

The Component Division will produce the materials at a variable cost of \(\\(190\) per unit and receive \(\\)210\) per unit. The profit per unit is \(\\(210 - \\)190 = \\(20\). For 50,000 units, the total increase in income is \(50,000 \times \\)20 = \$1,000,000\).

Step 4: Calculate Total Income Increase for Monumental Motors

The total income increase for Monumental Motors is the sum of the income increases from both divisions: the Truck Division's increase of \(\\(2,500,000\) and the Component Division's increase of \(\\)1,000,000\). Thus, the total increase is \(\\(2,500,000 + \\)1,000,000 = \$3,500,000\).

Key Concepts

Cost Savings

Cost savings is a critical concept in business operations, and it involves reducing expenses to increase profitability. In the context of the exercise, the Truck Division of Monumental Motors can achieve cost savings by sourcing materials internally rather than externally. The materials currently purchased from outside suppliers cost $260 per unit, whereas the Component Division can supply them at a reduced transfer price of $210 per unit. This results in a significant saving of $50 per unit. With 50,000 units being transferred, the total cost savings amount to $2,500,000. These savings directly contribute to increased profitability without compromising the quality or availability of materials.

Inter-Divisional Transfer

Inter-divisional transfer refers to the movement of goods or services between different divisions within the same company. This internal process helps in optimizing resource utilization and enhancing efficiency. In this exercise, the Truck Division and the Component Division engage in such a transfer. The Truck Division benefits from obtaining necessary materials at a reduced cost, while the Component Division maximizes its unused capacity by producing additional units. By setting a transfer price of $210 per unit, both divisions not only manage costs effectively but also maintain flexibility in operations, which is especially beneficial when external markets are volatile or expensive.

Income from Operations

Income from operations is a measure of a company's profitability from its core business activities. It is calculated by subtracting operating expenses from the revenue generated by the business, excluding any income from non-operational sources. In the context of Monumental Motors, the inter-divisional transfer positively impacts the income from operations for both divisions involved. The Truck Division sees an increased income of $2,500,000 due to the cost savings achieved from the lower transfer price. Similarly, the Component Division realizes an increase of $1,000,000 to its income from operations because of the profits generated from the transfer price exceeding their variable cost. The total income increase for Monumental Motors is a substantial $3,500,000, demonstrating how strategic internal transfers can enhance operational profitability.

Variable Cost

Variable costs are direct costs that vary with the level of production or business activity. Unlike fixed costs, which remain constant regardless of production levels, variable costs increase or decrease in direct proportion to the amount produced. In the scenario provided, the Component Division's variable cost per unit is $190, which indicates the cost to produce each unit of material that will be transferred to the Truck Division. Since these materials can be produced using unused capacity, the Component Division can make them without incurring additional fixed costs. The exercise also illustrates how understanding and managing variable costs allows businesses to set transfer prices strategically, thus benefiting both divisions involved in the transaction.