Reference no: EM131568890

Problem -

Gamma Division of Fava Corporation produces electric motors, 20% of which are sold to Fava's Omega Division and 80% to outside customers. Fava treats its divisions as profit centers and allows division managers to choose whether to sell to or buy from internal divisions. Corporate policy requires that all interdivisional sales and purchases be transferred at variable cost. Gamma Division's estimated sales and standard cost data for the year ended December 31, based on a capacity of 60,000 units, are as follows:

	Omega	Outsiders
Sales	$660,000	$5,760,000
Less: Variable costs	660,000	2,640,000
Contribution margin	$ -----	$3,120,000
Less: Fixed costs	175,000	900,000
Operating income (loss)	$(175,000)	$2,220,000
Unit sales	12,000	48,000

Gamma has an opportunity to sell the 12,000 units shown above to an outside customer at $80 per unit. Omega can purchase the units it needs from an outside supplier for $92 each.

Required:

A. Assuming that Gamma desires to maximize operating income, should it take on the new customer and discontinue sales to Omega? Why? (Note: Answer this question from Gamma's perspective.)

B. Assume that Fava allows division managers to negotiate transfer prices. The managers agreed on a tentative price of $80 per unit, to be reduced by an equal sharing of the additional Gamma income that results from the sale to Omega of 12,000 motors at $80 per unit. On the basis of this information, compute the company's new transfer price.