Question

Fact Pattern:

National Industries is a diversified corporation with separate and distinct operating divisions. Each division’s performance is evaluated on the basis of total dollar profits and return on divisional investment. The WindAir Division manufactures and sells air-conditioning units. The coming year’s budgeted income statement, based upon a sales volume of 15,000 units, appears below. WindAir Division Budgeted Income Statement For the Next Fiscal Year Per Total Unit (000 omitted) Sales revenue $400 $6,000 Manufacturing costs Compressor $  70 $1,050 Other materials 37 555 Direct labor 30 450 Variable overhead 45 675 Fixed overhead 32 480 Total manufacturing costs $214 $3,210 Gross margin $186 $2,790 Operating expenses Variable selling $  18 $   270 Fixed selling 19 285 Fixed administrative 38 570 Total operating expenses $  75 $1,125 Net income before taxes $111 $1,665 WindAir’s division manager believes sales can be increased if the unit selling price of the air conditioners is reduced. A market research study conducted by an independent firm indicates that a 5% reduction in the selling price ($20) will increase sales volume by 16%, or 2,400 units. WindAir has sufficient production capacity to manage this increased volume with no increase in fixed costs.

WindAir currently uses a compressor in its units that it purchases from an outside supplier at a cost of $70 per compressor. The division manager of WindAir has approached the manager of the Compressor Division regarding the sale of a compressor unit to WindAir. The Compressor Division currently manufactures and sells a unit exclusively to outside firms that is similar to the unit used by WindAir. The specifications of the WindAir compressor are slightly different, which will reduce the Compressor Division’s materials costs by $1.50 per unit. In addition, the Compressor Division will not incur any variable selling costs for the units sold to WindAir. The manager of WindAir wants all of the compressors it uses to come from one supplier and has offered to pay $50 for each compressor unit. The Compressor Division has the capacity to produce 75,000 units. The coming year’s budgeted income statement for the Compressor Division is shown below and is based upon a sales volume of 64,000 units without considering WindAir’s proposal. Compressor Division Budgeted Income Statement For the Next Fiscal Year Per Total Unit (000 omitted) Sales revenue $100 $6,400 Manufacturing costs Materials $  12 $   768 Direct labor 8 512 Variable overhead 10 640 Fixed overhead 11 704 Total manufacturing costs $  41 $2,624 Gross margin $  59 $3,776 Operating expenses Variable selling $    6 $   384 Fixed selling 4 256 Fixed administrative 7 448 Total operating expenses $  17 $1,088 Net income before taxes $  42 $2,688

Question

If National Industries requires the Compressor Division to sell 17,400 compressors to WindAir, how much is the effect on the corporation’s pretax earnings?

• A.$(409,600)

• B.$722,100

• C.$312,500

• D.$(215,400)

Answer 1

How much is the effect on the corporation’s pretax earnings?

Answer : C.$312,500

1. $374,100 Contribution margin from sales to WindAir (17,400 ($50 - $10.50 - $8 - $10)). Loss in contribution margin from loss of sales to outsiders: Total unit capacity Sales to WindAir Balance ..... Projected sales to outsiders.. Lost sales to outsiders........ (6,400 ($100 - $12 - $8 - $10 - $6) Estimated decrease in Compressor Division contribution margin and in income before income tax if WindAir's needs are supplied 75,000 17,400 57,600 64,000 6,400 409,600 $ 35,500 The Compressor Division would find it desirable, from its own viewpoint, to accept orders from WindAir above the 64,000-unit outside customer demand level, up to its 75,000-unit capacity, because there would be a positive contribution margin of $21.50 per unit. $ 70.00 Cost savings by using units from Compressor Division: Outside purchase price Compressor Division's variable cost to produce ($10.50 + $8 + $ 10) .... Savings per unit. Number of compressors Total cost savings... Less Compressor Division's lost sales to outsiders (6,400 $64 (see requirement 2))).... Increase in income before income tax for National Industries 28.50 $41.50 x 17,400 $722,100 409,600 $312,500 The decision should be based on what is best for the total firm. It would be in the best interests of National Industries for the Compressor Division to sell the units to the

WindAir Division. The net advantage to National Industries is $312,500, as shown in the above calculations. Since each division is evaluated based on its profits and return on division investment, the expectations for the two divisions should be adjusted because of the effect of this decision on individual divisional performance.