Question 10.4

(Total: 34 marks)

Big Machines Corp. has two divisions. Division Y manufactures components that can be sold in the external market place or transferred to Division Z for further processing. The following data relate to Division Y's component product.

Variable manufacturing costs/unit	$925
Fixed costs/unit at capacity	$275
Selling price/unit	$1,800

The capacity of the plant is 2,500 units per year.

Division Z has offered to purchase 350 units from Division Y at a price of $1,600/unit, which is the market price of the component. The manager of Division Y has refused this offer stating that it would only return a rate of 25.00%, when the divisional target return on sales is 28.00%. The Division Y manager also states that additional fixed costs of $195,000 would be required to produce the 350 units.

The corporate required rate of return is 18% of assets and the existing asset base in Division Y is $2,500,000.

Required:

1. How many units must Division Y sell in order to achieve its required ROR? What profit margin would be earned at this level of sales?
2. (8 marks)

1. Assume Division Y currently sells 2,000 units to the external market and can accept Division Z's offer without affecting its external sales. Evaluate the refusal of Division Z's offer from the standpoint of the corporation as a whole and from Division Y manager's perspective.
2. (18 marks)

1. Assume Division Y currently sells 2,000 units to the external market and can accept Division Z's offer without affecting its external sales. Calculate Division Y's residual income with and without the sale to Division Z.
2. (8 marks)