Question

The West and East Divisions are divisions in the same company. Currently the East Division buys a part from West Division for $384 per unit. The West Division wants to increase the price of the part it sells to East Division by $96 to $480. The manager of the East Division has stated that he cannot pay that much insofar as the division's profit goes below zero. The manager of the East Division can buy the part from an outside supplier for $440 per unit. The cost data pertaining to the part is supplied by the West Division:

Direct materials              $136

Direct labor                       200

Variable overhead               40

Fixed overhead                   42

If West Division does not produce the parts for the East Division, it will be able to avoid one-third of the fixed manufacturing overhead costs. The West Division has excess capacity but no alternative uses for the facilities. From the standpoint of the company as a whole, should the East Division buy the part from the West Division or the outside supplier?

		1. East Division should buy the part from the West Division because the company's profit will be $14.00 per unit larger.
		2. East Division should buy the part from the West Division because the company's profit will be $40.00 per unit larger.
		3. East Division should buy the part from the West Division because the company's profit will be $50.00 per unit larger.
		4. East Division should buy from an outside supplier at $440 per unit.

Answer 1

Ans. Total cost of west division = 136+ 200+ 40+ 42

= $ 418

Profits earned by company if east division purchase from west division = $ 440 - $ 418

= $22

Unavoidable fixed overhead that company will incur if west division do not sell to east division = (42 *2) /3

= $ 28

Overall profit of company if west division sells to east division = $ 22 + $ 28

= $ 50

Option 3 is correct ( East Division should buy the part from the West Division because the company's profit will be $50.00 per unit larger).

Note: Avoidable fixed costs are 1/3, so balance are unavoidable fixed costs (i.e., 2/3).