Franklin Industrial Equipment Corporation manufactures lawn mowers and snow blowers. It also manufactures engines that are used by the Lawn Mower Assembly Division (LMAD). The Engine Division (ED) also sells about 40% of its output to the outside market (these are multipurpose engines). Its annual capacity is 150,000 units and annual output is 135,000 units. All engines sold internally to the LMAD are priced at cost plus 20% markup.In January 2020, the Snow Blower Assembly Division (SBAD) approached the ED to 'buy' 20,000 engines. Jean Wyse, the controller of ED, computed the costs of manufacturing these engines as follows: Total Per unitMaterials$300,000 $15.00 Labor 400,000 20.00 Special equipment 36,000 1.80 Quality inspection 24,000 1.20 Other manufacturing
costs 350,000 17.50 Total costs$1,110,000 $55.50 Wyse quoted a price of $66.60 for each engine transferred to the SBAD. Jeb Hart, the manager of SBAD, was furious to note that the ED was "trying to make money off a sister division." He argued that the price must include only the cost of materials, as all other costs will be incurred irrespective of whether or not SBAD places the order for 20,000 engines. Mark Matley, the production manager of ED, pointed out that the special equipment will be purchased only for fulfilling this internal order. Moreover, he argued that inspection must also be done just like on all other engines; therefore, the inspection costs must also be included. Labor is paid a flat monthly salary. Other manufacturing costs include both variable and fixed components (in roughly equal proportion).Required:(a) Given that excess capacity exists, what is the minimum price that the ED should charge to the SBAD?(b) What are the pros and cons of internal sourcing?
What will be an ideal response?
(a) The costs that are explicitly associated with the manufacture of engines required by the SBAD are as follows:
| Materials: | $ | 300,000 | ||||
| Special equipment: | 36,000 | |||||
| Inspection: | 24,000 | |||||
| Other manufacturing costs: | 175,000 | |||||
| Total | $ | 535,000 | $ | 26.75 | per unit |
It is important to note that excess capacity exists; therefore, the ED does not have any opportunity costs associated with the SBAD order.
(b) The pros of internal sourcing are as follows:
? Productive use of excess capacity.
? Potential cost savings.
? Protection of proprietary knowledge.
The cons of internal sourcing are as follows:
? Setting internal pricing policies and refereeing disputes.
? Supporting inefficient operations with artificially high internal prices.
It is important to note that any policy stated as "cost plus 20 percent" is asking for trouble, because "cost" is undefined. If market prices are available, the company probably should use these for internal sales, with a policy of sourcing internally at the market price. Using cost-based internal prices may be necessary, but it creates the complications of creating the price that motivates managers to benefit themselves and the company as a whole.
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