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Dear Sir,
please help me to understand the logical explanation for the following example.Division A makes units and transfers to other divisions. There is a competitive intermidiate market for these units with a price of $15 per unit. Division A then incurs a selling cost of $2. Variable production cost is $7 per unit and fixed cost $3 per unit. Division has spare capacity.
They give the following statement as a correct one:
Any price above variable cost will generate a postive contribution, and will therefore be accepted.
But what about fixed cost for this division? we don’t consider it? Sorry, if I again missed something from your lectures.
And many thanks for your answers.
And also, for the following question they give the following correct answer (provided that in this case there is no spare capacity and also they don’t mention costs – variable or fixed, don’t mention them at all.)
This statement:
The division will need to give up a unit sold externally in order to make a transfer, this is only worthwhile if the income of transfer is greater than the net income of external sale.
So, this is because we have limited capacity, yes?
In answer to your first question:
Unless told differently, we always assume that the division make lots of products and that we are just looking at one of them. Therefore the total fixed costs of the division will remain unchanged and it is therefore only the variable/marginal cost of the product that is relevant.
In answer to your second question:
Yes it is because of limited capacity. However it is better to use the rule that I give in the lecture (marginal cost plus any lost contribution) because the last example I go through does not work using the statement that you have quoted.
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