Question

Rabbid Industries Ltd consists of three decentralized divisions: Brentwood Division, Crater Division and Dollar Division. The managing director of Rabbid Industries has given the managers of the three divisions the authority to decide whether to sell their products outside the company or between themselves at a transfer price determined by the division managers. The external market for the companys products is very active and there are many competitors, so sales made internally or externally by the division will not affect the market prices. Intermediate markets will always be available for Brentwood, Crater and Dollar to purchase their manufacturing needs or sell their products. Each division manager attempts to maximize his contribution margin at the current level of operating assets for the divisions.

The manager of Crater Division is currently considering the following two orders:

• Dollar Division needs 3000 units of a motor that can be supplied by Crater Division. To manufacture these motors, Carter would purchase components from Brentwood Division at a transfer price of $900 per unit. Brentwoods variable cost for theses components is $450 per unit. Crater Division would further process these components at a variable cost of $750 per unit.
• Eros Company wants to order 3500 motors from the Crater Division. This is a custom built product and the price will be $1875 per unit. Crater would purchase components for these motors from Brentwood Division at a transfer price of $750 per unit. Brentwoods variable cost for these components is $375 per unit. Crater Division will further process these components at a variable cost of $600 per unit.

Crater Division plant capacity is limited, and the company can accept either the Eros order or the Dollar order but not both. The managing director of Rabbid Industries and the manager of Crater Division agree that it would not be beneficial to increase capacity. If Dollar Division cannot obtain the motors from Crater Division, it will purchase the motors from Frantic Company which has offered to supply the same motors to Dollar Division at a price of $2250 per unit. Frantic Company would also purchase 3000 components from Brentwood Division at a price of $600 for each of these motors. Brentwoods variable cost for these components is $300 per unit.

Required:

1. Independent of your answer to requirement 1, assume that Crater Division decides to accept the Eros Company contract. Determine if this decision is in the best interests of Rabbid Industries.

Answers

Crater Divisions decision to accept the contract from Eros Company is in the best interest of Rabbid Industries Ltd as the decision increases the overall contribution margin of the company. This conclusion is supported by the following calculations.

Revenues and cost savings to Rabbid Industries Ltd:

Sales by Crater to Eros (3500 units @ $1875 each) $6 562 500

Sales by Brentwood to Frantic (3000 units @ $600 each) 1 800 000

Cost savings (variable costs avoided by not accepting the Dollar order)

Brentwoods savings (3000 units @ $450) 1350 000

Craters savings (3000 units @ $750) 2 250 000

Total revenue and cost savings $11 962 500

Expenditures incurred by Rabbid Industries Ltd:

Variable cost incurred for the Eros order:

Crater (3500 units @ $600 each) $2 100 000

Brentwood (3500 units @ $375 each) 1 312 500

Variable cost incurred for purchase:

Dollar from Frantic (3000 units @ $2250 each) 6 750 000

Frantic from Brentwood (3000 units @ $300 each) 900 000

Total expenditures incurred 11 062 500

Additional contribution margin to Rabbid Industries Ltd $900 000

I need explanation why the answers do not include Cost Savings of $900?