Question

A company has two divisions and evaluates management using return on investment. Division 1 currently makes a part that it sells to Division 2 and to outside customers. The selling price to Division 2 is $25, variable cost is $18, and fixed costs are $80,000. Division 1 wants to increase the selling price to $28.

Division 2 can purchase the same part from an outside supplier for $26; however, if Division 2 gets the parts from the outside supplier, Division 1 will end up with excess capicity.

From an overall company perspective:

a. Division 1 should continue to do business with Division 2 and charge $28 per part.

b. Divison 1 should continue to do business with Division 2 and charge $25 per part.

c. Division 1 should continue to do business with Division 2 because Division 1's variable cost per part is only $18.

d. Division 2 should do business with the outside supplier.

e. Division 2 should split its business between Division 1 and the outside supplier.

Answer 1

c. Division 1 should continue to do business with Division 2 because Division 1's variable cost per part is only $18.

Step-by-step explanation:

Since the variable cost per part is only $18 and Division 1 sells to Division 2 at $25, it is in the company's overall interest that business should continue between the two divisions.

The cost of getting the part from outside is $26. This will incur more cost to the company and create excess capacity for Division 1.

Fixed costs are not relevant in making a decision of this nature. The costs would be incurred irrespective of the decision made. They are therefore irrelevant. The relevant cost is the variable cost of $18 per unit. It should be the focus of the decision, including the possibility of excess capacity for Division 1.