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Lyon Toys, Inc. (LTI) manufactures a variety of electronic toys for children aged 3 to 14
years. The company started as a Ma & Pa basement operation, and grew steadily over the
last nine years. It now employs over 100 people and has sales revenue of over $250
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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 2016, 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 unit
Materials
$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 must charge
to the SBAD?
(b) What are the pros and cons of internal sourcing?
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