Y5

This Memo presents a scenario where students must consider making decisions based on marginal cost instead of average fixed cost.

I've just arrived back from meetings with the president of our company in Washington, D.C. As you know the stock price of our parent company has been suffering and the president is under pressure to boost profits. To this end, the company has decided to set internal rate of return targets on all US divisions and on all foreign subsidiaries.

I contacted our sales and logistics divisions on the plane trip back and the latest information I have is as follows:

1. The negotiated wholesale distribution price is fixed at $7.54 per pair.

2. Based on conversations I have had with our production engineers, they insist that the standard factory design costs are quadratic. (specifically, it follows the form total cost = a + bQ2 functional form)

3. The accounting department has analyzed your production costs from an internal audit of the last 8 years and estimated that the cost function is C(Q) = 115.72 + 0.063Q2

I have determined that based on this data, production has been exceeding your monthly quota of 30,000 pairs in most months. Your average cost is also higher than the target $5 per pair established by headquarters. You need to limit your production, as it is too costly.

I want you to implement these production changes in the Malaysia factory immediately, or give a justification of why you should maintain higher production runs.