Yellow Company’s Ax division has capacity of 200,000 units. Normal selling price

Question

Yellow Company’s Ax division has capacity of 200,000 units. Normal
selling price is $22.00 per unit. At current operating levels, fixed costs are
$4 per unit and variable costs are $8 per unit. Another division of Yellow
Company would like to buy from the Ax division.
Assume that the Ax division
is operating at 80% of capacity. The Hatchet division would like to purchase
20,000 units. No variable cost would be avoided on the sale. What is the lowest
price the Ax division would accept if it wishes to see no decline in
profits? (Points : 2)
     
$6
     
$22
     
$20
     
$8

Explanation / Answer

Currently, the Ax division is operating at 80% of capacity, creating 200,000 units. This means that maximum capacity will be 250,000 units. Assuming that creating more units will not cause a substantial increase variable costs, Ax division will charge FC + VC to the hatchet division, because Ax division can increase its output in order to meet the new demand.

Math:
200,000 units * ($22 -(4+8)) = 2,000,000 profit

With new demand:
200,000 units * (22 - (4+8)) = 2,000,000 profit
+ 20,000 units * (12 - (4+8)) = 0 Profit
Total profit is the same, thus meeting the conditions.

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