Green Lawn Mower, Inc., recently acquired Hallit Engines, a small engine manufacturing company. Green’s president believes in decentralization and intends to permit Hallit to continue to operate as an independent entity. However, she has instructed the manager of Green’s lawn mower assembly division to investigate the possibility of purchasing engines from Hallit instead of using the current third-party supplier. Hallit has excess capacity. The current full cost to produce each engine is $96. The avoidable cost of making engines is $78 per unit. The assembly division, which currently pays the third-party supplier $90 per engine, offers to purchase engines from Hallit at the $90 price. Hallit’s president refuses the offer, stating that his company’s engines are superior to those the third-party supplier provides. Hallit’s president believes that the transfer price should be based on the market price for independent cus tomers, which is $132 per engine. The manager of the assembly division agrees that Hallit’s engines are higher quality than those currently being used but notes that Green’s customer base is in the low-end, discount market. Putting more expensive engines on Green mowers would raise the price above the competition and would hurt sales. Green’s president tries to negotiate a settlement between the assembly manager and Hallit’s president, but the parties are unable to agree on a transfer price.
Required
a. Assuming that Green makes and sells 40,000 lawn mowers per year, what is the cost of sub optimization resulting from the failure to establish a transfer price?
b. Assume that you are a consultant asked by the president of Green to recommend whether a transfer price should be arbitrarily imposed. Write a brief memo that includes your recommendation and your justification for making it.