Holiday, Inc. has been in business for over 75 years, making a variety of holiday related items. Tiny Elf, recently joined the business as vice president of the Inflatables Division, one of the company’s newest divisions. During his first week on the job, Tiny met with CEO Winter E. Wonderland to discuss the division’s future.
“I know we’re one of the newest and smallest division in the company,” Tiny said, “but I think we’re in a position to realize some dramatic growth through product line expansion. We’ve got a full pipeline of products under development, and I’d like to speed up development of a couple of those products. If we work hard, I think we can have the new Rapid Inflator ready for release by the end of the year.”
Winter thought for a minute and then replied. “That sounds like a good idea, Tiny. I just don’t want you to move so fast that you don’t have a good understanding of how the introduction of the new products will impact the division’s performance. Remember, I’m a big fan of maintaining our return on investment.”
Tiny went back to his office after the meeting and began to crunch the numbers on the rapid inflator. At a price of $10 per unit, the marketing department estimates demand for the product at 40,000 units. The division will need to purchase a new machine for $100,000 to produce the inflator. Mary estimates that the division will incur an additional $140,000 in fixed costs that are directly attributable to the inflator.
One component of the inflator is currently produced by Holiday’s Lighting Division at a variable cost of $3 per unit. The component is sold to outside customers (other manufacturers) for $5 per unit. Tiny met with Sammy Shine, vice president of the Lighting Division, earlier in the week to discuss the possibility of the Lighting division supplying the component to the Inflatables Division. “Sure,” Sammy began, “I’d like to help you out on this. We can provide the components at our market price of $5 per unit. We have the capacity to make 150,000 of the components, and we’re currently making only 135,000 for our external customers.” Tiny thanked Sammy for his time saying, “I’ll get back to you next week,”
The Inflatables Division currently earns $250,000 on $2.5 million in sales revenue. The division has an asset base of $1,250,000. Tiny knows that Winter will not be happy if the new product reduces the division’s return on investment and he is concerned that Sammy’s offer to sell the component at $5 per unit will push product costs too high tot maintain the division’s ROI. He thinks that if he can meet with Sammy again to explain the situation, maybe he can negotiate a lower transfer price.