Compute The Operating Income For Division C

Compute the operating income for Division C under the current agreement and the proposed agreement

Coffee Makers Incorporated (CMI) faces a complex situation involving interdivisional transactions, external supplier options, and declining costs, which directly impact profit margins and transfer pricing policies across its divisions. The scenario involves three divisions: A, B, and C, with C acting as the supplier of parts to A and B. The recent changes in external market prices prompt a reassessment of current transfer prices and procurement strategies, necessitating detailed financial analysis.

Division A currently purchases 2,700 units of Part 101 from Division C at a transfer price of $1,000 per unit, and 1,300 units from an external supplier at market price of $900 per unit. The total cost of internal purchases is 2,700 units × $1,000 = $2,700,000, and external purchases amount to 1,300 units × $900 = $1,170,000, totaling $3,870,000. Under the proposal, Division A plans to buy 2,000 units from Division C at the existing transfer price and 2,000 units externally at market price, reducing internal purchases and potentially influencing Division C’s profitability.

Similarly, Division B’s current purchase volume includes 1,100 units of Part 201 at a transfer price of $2,000 per unit and 700 units externally at the market price of $1,800 per unit. The internal purchases total 1,100 units × $2,000 = $2,200,000; external purchases are 700 units × $1,800 = $1,260,000, summing to $3,460,000. The proposed arrangement involves purchasing 900 units from Division C and 900 units externally, again shifting purchase volumes and costs.

Calculations of Operating Income for Division C

Operating income for Division C can be calculated by subtracting variable expenses and fixed overhead from total revenue. The current agreement provides a basis for understanding Division C’s profitability before considering the proposal, which can then be compared to evaluate potential improvements or declines in operating income.

In the current situation, Division C’s revenue from Part 101 is 2,700 units × $1,000 = $2,700,000. Its variable expenses are 2,700 units × $700 = $1,890,000. Similarly, revenue from Part 201 is 1,100 units × $2,000 = $2,200,000, with variable expenses of 1,100 units × $1,200 = $1,320,000.

The total revenue is $2,700,000 + $2,200,000 = $4,900,000, and total variable expenses are $1,890,000 + $1,320,000 = $3,210,000. Deducting variable expenses from revenue yields a contribution margin of $1,690,000. From this, the fixed overhead of $1,200,000 is deducted, resulting in an operating income of $490,000 under the current agreement.

Under the proposed agreement, revenue from internal sales for Part 101 is 2,000 units × $1,000 = $2,000,000, and from external sales, 2,000 units × $900 = $1,800,000. Total revenue shifts accordingly, with similar calculations applied to Part 201. It is crucial to recognize that external sales may replace some or all of internal sales, affecting overall profitability and operational efficiency for Division C.

Conclusion and Financial Implications

Comparing the operating income under the current and proposed arrangements reveals the impact of internal versus external sales strategies. If external sales generate higher margins, the proposal can enhance Division C’s profitability and overall corporate income. Conversely, internal sales at transfer prices that do not reflect market value can suppress operating income, suggesting a need for flexible transfer pricing policies that align with market conditions.

References

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