The Falco Group is a holding company with majority ownership of numerous business-to-business and business-to-consumer firms. The company’s flagship consumer holding is the wholly-owned Falco Scooter Company. It currently offers two models: the City-100 and the Super-300.

The City-100 model has a maximum speed of 50 mph; consequently, it is not allowed on most expressways. The higher-end Super-300 uses a larger engine and enhanced safety systems; with its maximum speed of 79 mph, it is approved for expressway riding in many areas.

The market for the City-100 is highly competitive – many competitors offer essentially identical scooters; the current prevailing market price is $660. At this price, Falco can sell any number of City-100’s (our current annual estimate is 5,000 – 6,000 unit sales).

The market for the Super-300 model is an oligopoly; Falco expects to sell 1,000 Super-300’s per year at the current price of $3,000.

Falco Scooters has a single state-of-the-art assembly facility, where both scooter models are assembled from parts purchased from a few well-chosen suppliers. One of the key strategies of the Falco Group is to strive to maximize capacity utilization. Consequently, the scooter manufacturing facility operates at its maximum practical capacity; the capacity constraint is equipment, measured in machine hours (MHs). The two models are assembled using the same employees and equipment.

The key difference between the two scooter models is Super-300’s more-powerful engine. Currently, the engine is purchased from an outside supplier for $300 per unit.

As part of its long-term growth strategy in the business-to-business segment, the Falco Group recently acquired all of the equity of Scorpion Motors – a small manufacturer of motorcycle engines. Scorpion Motors makes and sells two engine models: Standard and Deluxe.

This particular acquisition was made in part because Scorpion Motors recently downsized, and currently the company’s single engine-manufacturing plant operates at its maximum capacity; the capacity constraint at the engine plant is skilled labor, measured in direct-labor hours (DLHs). The same employees manufacture both engine models using the same equipment.

The market for the Standard engine is highly competitive; at the prevailing market price of $75, Scorpion Motors can sell any number of Standard engines (our current annual estimate is 20,000 – 25,000 annual unit sales).

The Deluxe engine is made for a single external customer, MG Motorcycles, under a long-term contract requiring Scorpion to deliver 2,500 Deluxe engines per year. The Deluxe uses a design developed and patented by MG Motorcycles; Scorpion Motors is not allowed to sell this engine to any other client.

A recent review of potential internal synergies revealed that a modified version of the Deluxe engine made at the Scorpion Motors Division could be successfully used by Falco Scooters for the Super-300, instead of the engine currently purchased. MG Motorcycles agreed to allow Scorpion to make this modified Deluxe for Falco Scooters for a licensing fee of $30,000 per year. Modifications to make the Deluxe fit on the Super-300 will require additional direct-materials (DM) costs at Scorpion Motors of $30 for each Modified Deluxe. Neither costs nor volumes of the Deluxe units made for MG Motorcycles will be affected.

Some additional information, collected from the two divisions’ normal-absorption reporting systems, is below:

Falco scooter Company, per unit information

	City- 100	Super-300
Selling Price	$660	$3000
Direct Material	$420	$1260
Machine Hours	1	4
Direct Labor	5 DLHs @ 30 per DLHs	20 DLHs @ 30 per DLHs
Variable Overhead Allocation	$6 per DLH	$6 per DLH
Fixed Overhead Allocation	$9 per DLH	$9 per DLH

Scorpion Motors, per unit information

	Standard	Deluxe
Selling Price	$75	$300
Direct Material	$15	$120
Machine Hours	1	3
Direct Labor	1 DLHs @ 30 per DLHs	2 DLHs @ 30 per DLHs
Variable Overhead Allocation	$15 per DLH	$15 per DLH
Fixed Overhead Allocation	$3 per DLH	$3per DLH

NOTE: Falco Group managers believe that variable overhead at each division is really driven by direct labor hours.

Required. When answering questions, focus on the real financial impacts of decisions considered by Falco Group (not the reporting consequences of the decisions). Ignore taxes. Keep in mind that both Falco Scooter Company and Scorpion Motors are wholly-owned subsidiaries of the Falco Group.

Question: Falco Scooters’ divisional managers’ bonus incentives are tied to the division’s net operating income (NOI, computed using GAAP). For various reasons, the division does not appear to be on track to meet the NOI target needed to earn bonuses for divisional managers. Falco Scooters’ controller notes that the unit margins on City-100’s are so low that the division would increase its NOI if its stops producing and selling City-100’s and instead make Super300’s for inventory.

a. While City-100’s unit contribution margin is low, it is still positive. Conceptually, how can the controller’s proposal – to stop producing and selling City-100’s and instead make Super-300’s for inventory – provide the division with a higher NOI?

b. Comment on the controller’s proposal. Are there any problems with this proposal? Is it a good idea from the point of view of the Falco Group’s shareholders?