Question

The following data apply to questions 5-9 The Santa Fe Manufacturing Company has two divisions in Kansas, the Holton Division and the Derby Division. Currently, Derby buys a part (10,000 units) from Holton for $16 per unit. Holton has purchased new equipment and wants to increase the price to Derby to $18 per unit. The controller of Derby claims that she cannot afford to go that high, as it will decrease the division's profit to near zero. Derby can buy the part from an outside supplier for $16 per unit. The incremental costs per unit that Santa Fe incurs to produce each unit are Holton's variable costs of $12. Fixed costs per unit for Holton with the recent purchase of equipment are $5.

Given Answer: C

Can someone help me with this question, please? the answer is C  but can someone give me a good explanation as to why? please help and thank you!

Answer 1

• If Holton sells the parts to Derby for $11, Holton makes a loss of $1 per unit from the transaction as it costs $12 to produce. Derby however makes a profit of $5 [being the difference between the market rate of $16 and the cost being $11]. However, Holton will not accept this price.
  
• If Holton sells the parts to Derby for $12 [which is the variable cost per unit], Holton makes no profit, while Derby makes a gain of $4 [being the difference between the market rate of $16 and the transfer price assumed here being $12] from this transaction. Total company gain will be $4.
  
• If Holton sells the parts to Derby for $13, Holton makes a profit of $1 per unit and Derby makes a gain of $3 per unit from this transaction. Total company gain will be $4.
  
• The pattern continues. If Holton sells the parts to Derby for $16, Holton makes a profit of $4 while Derby does not make any profit from this transaction.
  
• If Holton sells the parts to Derby for $17, Holton makes a profit of $5 while Derby makes a loss of $1. This will not be accepted by Derby.
  
  Therefore, the acceptable range is $12 to $16.
  
  But if the market price goes down to $11, then Holton will incur a loss if Holton produces the goods and sells to Derby as the cost of production is $12 per unit, and at $11 from Holton, Derby does not make any profit or loss from the transaction as it is same as market price. Thus the company will make a loss of $1 if Holton sells the product to Derby at $11.
  
  So, it is advised that Holton discontinues the production, and Derby purchases from external supplier, at which rate the company will not make a loss, and Derby will get the fair market deal.