Division S sells its product to unrelated parties at a price of $20 per unit. It incurs variable costs of $7 per unit and has fixed costs of $50,000 per month. Monthly production is generally 10,000 units.Division B uses Division S's product in its operations. It can purchase the units from Division S at $20 per unit but must pay $1.50 per unit in shipping costs. Alternatively, Division B can buy from Division S's competition at a delivered price of $21 per unit.Required:(a) From the company's perspective, should Division B purchase the units internally or externally? Assume Division S has ample capacity to handle all of Division B's needs.(b) Would your answer change if Division S can sell everything it produces to outside customers?

Question

What will be an ideal response?

Answer 1

(a)
The external cost is $21 and the internal cost is $8.50 ($7 variable cost + $1.50 shipping).  Division B should purchase the units internally because it would result in cost savings of $125,000 [($21 ? $8.50) × 10,000 units].
(b)
If Division S can sell everything it produces to outside customers, Division B should purchase the units externally.  The transfer price would be market because Division S is operating at capacity.  Purchasing internally would cost $21.50 ($20 + $1.50) per unit while purchasing externally would cost $21 per unit.