Kevin DenAdel is the chief executive officer of a biotechnology firm that specializes in developing disease- and drought-resistant strains of wheat, corn, and soybeans. The firm is organized into three divisions, with separate staff, facilities, and equipment. However, because the underlying science is similar, all three divisions use the same technology, albeit with differing intensity. The current debate centers on the cost of the DNA sequencing machine.

Wheat Division: We currently sequence about 1,000,000 base pairs each year at a cost of $0.45 per base pair. We looked into getting our own machine. We found one that has enough capacity. Its annual fixed cost is $400,000. As per industry standards, variable costs would be $0.10 per base pair, regardless of scale. So, we are still getting the sequencing done by a reliable vendor.

Corn Division: We are in the same boat, although our volume is only 500,000 base pairs a year. We can get a small machine, but it is not cost-effective. It will cost us close to $0.55 per pair when we can get it done outside for $0.45 per pair. When our volume increases, as we anticipate, we may revisit this issue.

Soybean Division: We are probably the least intensive users of sequencing. Maybe we make 100,000 pairs in a year, and it is simply not viable for us to get a machine. The smallest machine will give us five times the capacity we need.

Knowing that the firm is currently paying $720,000 for DNA sequencing, Kevin is looking into buying a machine to satisfy the needs of all three divisions. He has found a machine that has a capacity of 2 million base pairs a year. This machine will trigger annual fixed costs of $550,000.

Required:

a. Calculate the change in the firm’s profit if Kevin decides to buy the machine and has all sequencing done internally.

b. What other factors should Kevin consider in his decision?

c. Suppose Kevin acquires the machine and instructs all divisions to do their sequencing in-house. How much cost should be allocated to each division?

d. The head of the Soybean Division argues that none of the fixed cost should be allocated to her division. She argues that the firm would have likely bought the machine whether her division wanted it or not, and that she is merely using the capacity that would otherwise go to waste. Evaluate the merits of this argument.