Lorax Electric Company manufactures a large variety of systems and individual components for the electronics industry. The firm is organized into several divisions, and division managers are given authority to make virtually all operating decisions. Management control over divisional operations is maintained by a system of divisional profit and return on investment measures that are reviewed regularly by executive management. The executive management of Lorax has been quite pleased with the effectiveness of the system it has been using, and believes 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 sells this component to its regular customers at $40 per hundred.
The Systems Division, which is operating at about 60% of 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 clock radios and popular electronic home entertainment equipment. This opportunity represents the first time any Lorax division has been successful at tapping the potentially lucrative Centonic Electric market. Centonic Electric has offered to pay $7.50 per clock system.
The Systems Division prepared an analysis of the probable costs needed to produce the clock systems. The amount that could be paid to the Devices Division for the integrated circuits, five of which are required for each clock system, was determined by working backward from the sales 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 below as follows: