LORAX ELECTRIC COMPANY Lorax Electric Company manufactures a large variety of sy
ID: 2560156 • Letter: L
Question
LORAX ELECTRIC COMPANY Lorax Electric Company manufactures a large variety of systems and individual components for the electronics industry. The firm is organized into several divisions with division managers given the authority to make virtually all operating decisions Management control over divisional operations is maintained by an incentive system based on divisional profit and return on investment measures which are reviewed regularly by top management. Top management of Lorax has been quite pleased with the effectiveness of the system it has been using and believes that the system is responsible for the company's improved profitability over the last few years. The Devices Division manufactures solid-state devices and is operating at capacity. The Systems Division has asked the Devices Division to supply a large quantity of integrated circuit IC378. The Devices Division currently is selling this component to its regular customers at $0.40 each. The Systems Division, which is operating at about 60 percent capacity, wants this particular component for a digital clock system. It has an opportunity to supply large quantities of these digital clock systems to Centonic Electric, a major producer of cdlock radios and other popular electronic home entertainment equipment. This is the first opportunity any of the Lorax divisions has had to do business with Centonic Electric. Centonic Electric has offered to pay $7.50 per clock system The Systems Division prepared an analysis of the probable costs to produce the clock systems. The amount that could be paid to the Devices Division for the integrated circuits was determined by working backward from the selling price. The cost estimates employed by the division reflected the highest per unit cost the Systems Division could incur for each cost component and still leave a sufficient margin so that the division's income statement could show reasonable improvement. The cost estimates are summarized as follows Proposed selling price $7.50 acer PriSc Pause SysRa Break , Bad 5/6 8 0 0Explanation / Answer
To, Lou Belcher, Manager, Device Division Jane Thomus, Manager, Sysem Division Sub : Opposition by your divisional office to transfer price of $0.40 for Integrated Circuit(IC378) as recommended by Arbitration Committee Dear Lou & Jane With regard to above subject, I can understand your stand on rejecting the transfer price of $0.40 as it may disturb your incentive system which is based on profitability and return on investment of each division. However, let me inform you, if you accept the transfer price of $0.40, the profitability of the Company as whole will be as follows System Division & Company as whole Device Division only for 5 IC378 Total Selling price 7.5 2 9.5 Less : Variable cost (2.75+0.40+1.35) 4.5 0.75 5.25 Contribution Margin 3 1.25 4.25 Less : Variable cost of Integrated chip-IC378 0.75 Contribution Margin 2.25 The above analysis shows that refusal of transfer price of $0.40 would results in opportunity Loss of doing business with Centonic Electric and making profit of $2.25 per unit as aginst 1.25 profit earned by Device division. If we deciede not to proceed with Clock System order from Centonic Electric, we would not lose the customer of Device divisions but considering the huge contribution margin shown by our new business with Centonic Electric, this sacrifice is worth good profitability for the company as whole. And there is enough incentive for Device division because it not losing its present contribution, as transfer price recommended is at par with market price. So, I am intervening in this conflict by enforcing the transfer price of $0.40 per chip as recommended by Arbitration Committee. I am doing this to protect the overall interest of our company. Regards Vice President, Operations Lorax Electirc.
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