CHAPTER 6COST CONCEPTS AND MEASUREMENT

MULTIPLE CHOICE 1. The foregone value associated with the current rather than next-best use of a given asset is called: a. current cost. b. replacement cost. c. historical cost. d. opportunity cost. ANS: !. Sun" costs: a. typically involve multiple units of output. b. do not vary across decision alternatives. c. come into play when #udging the costs of adding a new product line$ advertising campaign$ production shift$ or organi%ation structure. d. play a role in determining the optimal course of action. ANS: & '. (n the short run$ the: a. firm has complete flexibility with respect to input use. b. availability of all inputs is fixed. c. operating period is longer than the planning period. d. availability of at least one input is fixed. ANS: ). (n the long run$ the: a. availability of at least one input is fixed. b. firm*s operating decisions are typically constrained by prior capital expenditures. c. availability of all but one input is fixed. d. firm has complete flexibility with respect to input use. ANS: +. The amount that must be paid for an item under prevailing mar"et conditions is: a. historical cost. b. replacement cost. c. incremental cost. d. current cost. ANS: ,. The ac-uisition cost of an asset is: a. a replacement cost. b. an implicit cost. c. an explicit cost. d. an opportunity cost. ANS: & .. (ncremental cost is the change in:

a. b. c. d.

total cost caused by a given managerial decision. noncash expenses caused by a given managerial decision. out-of-poc"et costs caused by a given managerial decision. variable cost caused by a given managerial decision.

ANS: A /. Noncash expenses are: a. explicit costs. b. sun" costs. c. incremental costs. d. implicit costs. ANS: 0. (n the decision process$ management should ignore: a. implicit costs. b. historical costs. c. sun" costs. d. incremental costs. ANS: 1 12. (n the decision process$ management should always consider: a. relevant costs. b. sun" costs. c. implicit costs only. d. historical costs. ANS: A 11. 3ixed costs include: a. variable labor expenses. b. output-related energy costs. c. output-related raw material costs. d. variable interest costs for borrowed capital. ANS: 1!. 4arginal cost e-uals: a. average variable cost at its maximum point. b. the change in total fixed cost divided by the change in -uantity. c. the change in total variable cost divided by the change in -uantity. d. total cost divided by -uantity. ANS: 1 1'. (ncremental cost: a. always e-uals marginal cost. b. never involves multiple outs. c. is the added cost tied to a given managerial decision. d. is typically less than historical cost. ANS: 1 1). (f the productivity of variable factors is decreasing in the short-run:

a. b. c. d.

marginal cost must increase as output increases. average cost must decrease as output increases. average cost must increase as output increases. marginal cost must decrease as output increases.

ANS: A 1+. (f the slope of a long-run total cost function decreases as output increases$ the firm*s underlying production function exhibits: a. constant returns to scale. b. decreasing returns to scale. c. decreasing returns to a factor input. d. increasing returns to scale. ANS: 1,. Average cost declines as output expands in a production process with: a. constant returns to scale. b. decreasing returns to scale. c. decreasing returns to a factor input. d. increasing returns to scale. ANS: 1.. (f a total product curve exhibits increasing returns to a variable input$ the cost elasticity is: a. e-ual to one. b. greater than one. c. un"nown$ without further information. d. less than one. ANS: 1 1/. 5ach point on a long-run average cost curve is the minimum: a. point on the short-run marginal cost curve. b. short-run average cost of production. c. long-run average cost of production. d. point on the short-run average cost curve. ANS: & 10. A firm*s capacity is the output: a. maximum that can be produced in the long-run. b. level where short-run average costs are minimi%ed. c. level where long-run average costs are minimi%ed. d. maximum that can be produced in the short-run. ANS: & !2. The amount paid is: a. historical cost. b. opportunity cost. c. current cost. d. replacement cost. ANS: A

!1. The change in cost caused by a given managerial decision is: a. implicit cost. b. incremental cost. c. explicit cost. d. opportunity cost. ANS: & !!. 1osts that do not vary across decision alternatives are: a. implicit. b. explicit. c. sun". d. economic. ANS: 1 !'. A cost-output relation for a specific plant and operating environment is the: a. short-run cost curve. b. long-run total cost curve. c. long-run marginal cost curve. d. long-run average cost curve. ANS: A !). The output level at which short-run average costs are minimi%ed is: a. minimum efficient scale. b. where multi-plant economies of scale e-ual one. c. where multi-plant economies of scale exceed one. d. capacity. ANS: !+. 6pportunity cost is not: a. a real economic cost. b. an implicit cost. c. a variable cost. d. none of these. ANS: PROBLEM 1. Cost Concepts. Answer each of the following as true or false. A. (f c 7 1$ increasing returns to scale and decreasing average costs are indicated. &. 1. Average cost exceeds marginal cost at the minimum efficient scale of plant. 8hen total fixed cost and price are held constant$ a reduction in average variable cost will typically cause a reduction in the brea"even activity level.

. An increase in total fixed cost will always increase the degree of operating leverage for firms ma"ing a positive net profit. 5. 8hen long-run average cost is decreasing$ it can pay to operate smaller plants at their pea"

efficiency rather than larger plants with some excess capacity. ANS: A. 3alse. 8hen c 7 1$ the percentage change in cost exceeds a given percentage change in output. This describes a situation of increasing average costs and diminishing returns to scale. &. 1. 3alse. The point of minimum average cost identifies the minimum efficient scale of plant. &y definition$ average and marginal costs are e-ual at this point. True. The brea"even activity level is where 9 : T31;<= - A>1?. As an average variable cost <A>1? decreases$ this ratio and the brea"even activity level will also decrease.

. True. The degree of operating leverage is defined 6@ : 9<= - A>1?;A9<= - A>1? - T31?B. Therefore$ when total fixed costs rise$ 6@ will increase as well. 5. 3alse. 8hen long-run average costs are declining$ it can pay to operate larger plants with some excess capacity rather than smaller plants at their pea" efficiency.

!. Cost Analysis. emand and supply conditions in the mar"et for uns"illed labor are an important concern to business and government decision ma"ers. 1onsider the case of a federally-mandated minimum wage set above the e-uilibrium or mar"et clearing wage level. Some of the following factors have the potential to influence the demand or -uantity demanded of uns"illed labor. (nfluences on the supply or -uantity supplied can also result. Colding all else e-ual$ describe these influences as increasing or decreasing$ and indicate the direction of the resulting movement along or shift in the relevant labor demand and;or supply curve<s?. 8ill wage rates rise or fallD A. An increase in the popularity of self-service restaurants$ gas stations$ and so on. &. 1. A rise in welfare benefits. A decrease in the -uality of secondary education.

. A rise in interest rates. 5. An increase in the minimum wage.

ANS: A. ESelf-serviceE gas stations$ restaurants$ car washes$ and so on$ involve a substitution of the consumer*s own labor for hired uns"illed labor. As self-service increases in popularity$ a decrease or leftward shift in the demand for uns"illed labor occurs. 8age rates will fall. &. 1. A rise in welfare benefits ma"es not wor"ing more attractive$ and will cause a decrease or leftward shift in the supply of uns"illed labor. 8age rates will rise. A decrease in the -uality of secondary education has the effect of decreasing wor"er productivity and will cause a decrease or leftward shift in the demand for uns"illed labor. To the extent that the disadvantages of a decrease in the -uality of education are recogni%ed by students$ fewer will stay in school and a secondary effect of an increase or rightward shift in the supply of uns"illed labor will also be observed. 8age rates will fall.

. Colding all else e-ual$ a rise in interest rates will decrease the attractiveness of capital relative to labor. 5mployers can be expected to substitute labor for the now relatively more expensive capital. An increase or rightward shift in the demand for uns"illed labor will result. 8age rates will rise. 5. An increase in the minimum wage will have the effect of decreasing the -uantity demanded of uns"illed labor$ while at the same time increasing the -uantity supplied. The first involves an upward movement along the demand curve$ while the second involves an upward movement along the supply curve. 8age rates will rise.

'. Incremental Costs. 5lectron 1ontrol$ (nc.$ sells voltage regulators to other manufacturers$ who then customi%e and distribute the products to -uality assurance labs for their sensitive test e-uipment. The yearly volume of output is 1+$222 units. The selling price and cost per unit are shown below: Selling price 1osts: irect material irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses Gnit profit before tax F!22 F'+ +2 !+ !+ 1+

1+2 F +2

4anagement is evaluating the alternative of performing the necessary customi%ing to allow 5lectron 1ontrol to sell its output directly to 9;A labs for F!.+ per unit. Although no added investment is re-uired in productive facilities$ additional processing costs are estimated as: irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses F!+ per unit F1+ per unit F12 per unit F122$222 per year

A. 1alculate the incremental profit 5lectron 1ontrol would earn by customi%ing its instruments and mar"eting directly to end users. ANS: A. This problem should be answered by using incremental profit analysis. The analysis deals only with the incremental revenues and costs associated with the decision to engage in further processing. (ncremental revenue per unit <F!.+ - F!22? (ncremental variable cost per unit <F!+ H F1+ H F12? (ncremental profit contribution per unit Iearly output volume in units (ncremental variable profit per year (ncremental fixed cost per year Iearly incremental profit .+ -+2 F !+ 1+$222 F'.+$222 - 122$222 F!.+$222 F

&ecause the incremental profit is positive$ the decision to engage in further processing would be more profitable than continuing the present operating policy.

). Incremental Costs. 3luff Jite$ (nc.$ manufactures stove top popcorn poppers that it sells to distributors$ who then customi%e and distribute the products to retailers as house-brand poppers. The yearly volume of output is 122$222 units. The selling price and cost per unit are shown below: Selling price 1osts: irect material irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses Gnit profit before tax F!2 F! + ! ' 1

1' F .

4anagement is evaluating the alternative of performing the necessary customi%ing to allow 3luff Jite to sell its output directly to retailers for F!, per unit. Although no added investment is re-uired in productive facilities$ additional processing costs are estimated as: irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses F! per unit F1 per unit F1 per unit F+2$222 per year

A. 1alculate the incremental profit 3luff Jite would earn by customi%ing its poppers and mar"eting directly to retailers. ANS: A. This problem should be answered by using incremental profit analysis. The analysis deals only with the incremental revenues and costs associated with the decision to engage in further processing. (ncremental revenue per unit <F!, - F!2? (ncremental variable cost per unit <F! H F1 H F1? (ncremental profit contribution per unit Iearly output volume in units (ncremental variable profit per year (ncremental fixed cost per year Iearly incremental profit , -) F ! 122$222 F!22$222 -+2$222 F1+2$222 F

&ecause the incremental profit is positive$ the decision to engage in further processing would be more profitable than continuing the present operating policy. +. Incremental Costs. (nfinite Audio$ (nc.$ manufactures car spea"ers which it sells to other resellers$ who then customi%e and distribute the products to retailers which sell hi-fi auto e-uipment. The yearly volume of output is '22$222 pairs. The selling price and cost per unit are shown below: Selling price 1osts: irect material irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses F1+2 F!+ )+ !2 1+ 12

11+

Gnit profit before tax

F '+

4anagement is evaluating the alternative of performing the necessary customi%ing to allow (nfinite Audio to sell its output directly to car stereo retailers for F!22 per unit under an in-house mar-uee. Although no added investment is re-uired in productive facilities$ additional processing costs are estimated as: irect labor >ariable overhead >ariable selling expenses 3ixed selling expenses F!2 per unit F1+ per unit F12 per unit F'22$222 per year

A. 1alculate the incremental profit (nfinite Audio would earn by customi%ing its instruments and mar"eting directly to end users. ANS: A. This problem should be answered by using incremental profit analysis. The analysis deals only with the incremental revenues and costs associated with the decision to engage in further processing. (ncremental revenue per unit <F!22 - F1+2? (ncremental variable cost per unit <F!2 H F1+ H F12? (ncremental profit contribution per unit Iearly output volume in units (ncremental variable profit per year (ncremental fixed cost per year Iearly incremental profit +2 -)+ F + '22$222 F1$+22$222 -'22$222 F1$!22$222 F

&ecause the incremental profit is positive$ the decision to engage in further processing would be more profitable than continuing the present operating policy. ,. Brea e!en Analysis. The Truc" Stop is a repair facility speciali%ing in the maintenance and repair of diesel engines #ust outside of 1arlisle$ =ennsylvania--one of the largest truc"ing hubs in the G.S. The business manager of the Truc" Stop has been as"ed by the owners to prepare a financial analysis of the potential of a !)-hour repair operation. 6pening such a center would re-uire remodeling the facility and the hiring of some additional staff. 5stimated first year expenses for the Truc" Stop*s diesel service center are: Support staff salary expense 4echanic Salary expense Supplies 5-uipment Jemodeling 5lectricity$ heat$ and taxes Total expenses F 1+$222 /2$222 )$222 +$222 12$222 /$222 F1!!$222

4echanic and staff salary expenses are estimated on an hourly basis$ reflecting additional salary and overtime costs. Supplies and remodeling expenses are above and beyond those re-uired for normal facility operations. 5-uipment costs represent a prorated share of the centers fixed e-uipment-leasing costs. 5lectricity costs of F!$222 reflect additional anticipated usage$ whereas heat and taxes of F,$222 reflect an allocated share of fixed expenses.

A. 1alculate brea"even revenue for the Truc" Stop*s proposed !)-hour diesel service center. ANS: A. The incremental brea"even revenue level is the revenue level that would #ust cover estimated incremental costs. (ncremental costs: Support staff salary expense 4echanic staff salary expense Supplies Jemodeling 5lectricity Total incremental costs and revenue brea"even level F 1+$222 /2$222 )$222 12$222 !$222 F111$222

5-uipment$ heat and tax expenses are fixed$ and irrelevant to the decision of opening a !)hour diesel service center. .. Brea e!en Analysis. &etty*s &outi-ue$ (nc.$ is a beauty salon speciali%ing in full-service beauty treatments: facials$ manicures$ waxes and tanning booths. The business manager for &etty*s has been as"ed by the owner to prepare a financial analysis of the potential of an extended hours operation. Such a move would re-uire remodeling the facility and the hiring of additional staff. 5stimated first year expenses for an extended hours operation are: Support staff salary expense &eautician salary expense &eauty supplies 5-uipment Jemodeling 5lectricity$ heat$ and taxes Total expenses F 1!$222 02$222 /$222 12$222 !)$222 !+$222 F1,0$222

&eautician and staff salary expenses are estimated on an hourly basis$ reflecting additional salary and overtime costs. Supplies and remodeling expenses are above and beyond those re-uired for normal facility operations. 5-uipment costs represent a prorated share of the centers fixed e-uipment-leasing costs. 5lectricity costs of F)$222 reflect additional anticipated usage$ whereas heat and taxes of F+$222 reflect an allocated share of fixed beauty shop expenses. A. 1alculate brea"even revenue for the proposed extended hours operation. ANS: A. The incremental brea"even revenue level is the revenue level that would #ust cover estimated incremental costs. (ncremental costs: Support staff salary expense &eautician staff salary expense &eauty supplies Jemodeling 5lectricity Total incremental costs and revenue brea"even level F 1!$222 02$222 /$222 !)$222 )$222 F1'/$222

5-uipment$ heat and tax expenses are fixed$ and irrelevant to the decision of opening a !) hour diesel service center. /. Brea e!en Analysis. The 4idtown 3illing Station is a gasoline retailer in enton$ Texas. @ouie e=alma$ proprietor of 4idtown$ has decided to prepare a financial analysis of the potential of a !)hour convenience store operation. 6pening such a center would re-uire remodeling the filling station and the hiring of additional cash register attendants$ but mechanics would still wor" only from /am to +pm. 5stimated first year expenses for the 4idtown*s service and convenience center are: 1ash register attendant salary expense 4echanic salary expense Supplies 5-uipment Jemodeling 5lectricity$ heat$ and taxes Total expenses F '2$222 /2$222 /$222 12$222 )+$222 1+$222 F1//$222

4echanic and attendant salary expenses are estimated on an hourly basis$ reflecting any additional salary and overtime costs. Supplies and remodeling expenses are above and beyond those re-uired for normal facility operations. 5-uipment costs represent a prorated share of the centers fixed e-uipmentleasing costs. 5lectricity costs of F'$222 reflect additional anticipated usage$ whereas heat and taxes of F!$222 reflect an allocated share of fixed expenses. A. 1alculate brea"even revenue for the proposed !) hour service and convenience center. ANS: A. The incremental brea"even revenue level is the revenue level that would #ust cover estimated incremental costs. (ncremental costs: Support staff salary expense Supplies Jemodeling 5lectricity Total incremental costs and revenue brea"even level F'2$222 /$222 )+$222 '$222 F/,$222

5-uipment$ mechanic salary$ heat and tax expenses are fixed$ and irrelevant to the decision of opening a !) hour service and convenience center. 0. Opport"nity Costs. Three graduate business students are considering operating a tofu burger stand in the alles$ 6regon$ windsurfing resort area during their summer brea". This is an alternative to summer employment with a local fruit cannery where they would earn F.$+22 each over the threemonth summer period. A fully e-uipped facility can be leased at a cost of F/$222 for the summer. Additional pro#ected costs are F!$222 for insurance$ and !+K per unit for materials and supplies. Their tofu burgers would be priced at F1.+2 per unit. A. 8hat is the accounting cost function for this businessD &. 1. 8hat is the economic cost function for this businessD 8hat is the economic brea"even number of units for this operationD <Assume a F1.+2 price and ignore interest costs associated with the timing of the lease payments.?

ANS: A. The accounting cost function is: Total Accounting 1ost : T1A : T1A : F/$222 H F!$222 H F2.!+9 : F12$222 H F2.!+9 &. The economic cost function is: Total 5conomic 1ost : Summer employment opportunity cost H T1 A : '<.$+22? H F12$222 H F2.!+9 : F'!$+22 H F2.!+9 The economic brea"even point is reached when: 9: : : !,$222 units 12. Opport"nity Costs. Two graduate business students are considering opening a full-service car wash in Lreenville$ North 1arolina$ after graduation. This is an alternative to employment with a local manufacturing firm where they would each earn F.2$222 per year. A fully e-uipped facility can be leased at a cost of F'+$222 for the year. Additional pro#ected costs are F1+$222 for overhead$ and F+ per automobile for materials and supplies. 3ull detail automobile cleaning would be priced at F!+. A. 8hat is the accounting cost function for this businessD &. 1. 8hat is the economic cost function for this businessD 8hat is the economic brea"even number of units for this operationD <Assume a F!+ price and ignore interest costs associated with the timing of the lease payments.? 3ixed leasing plus insurance costs H >ariable materials plus supplies costs

1.

ANS: A. The accounting cost function is: Total Accounting 1ost : T1A : : F'+$222 H F1+$222 H F+9 : F+2$222 H +9 &. The economic cost function is: Total 5conomic 1ost : 5mployment opportunity cost H T1A : !<F.2$222? H F+2$222 H F+9 : F102$222 H F+9 The economic brea"even point is reached when: 9: : 3ixed leasing plus overhead costs H >ariable materials plus supplies costs

1.

: 0$222 automobiles 11. Opport"nity Costs. Three Gniversity of 3lorida engineering students are considering operating a mobile car clinic in Lainesville$ 3lorida$ during their summer brea". This is an alternative to summer employment stac"ing plastic cups at a local in#ection molding manufacturer where they would earn F12$222 each over the three-month summer period. A van e-uipped for such service can be leased at a cost of F+$222 for the summer from an owner ta"ing a long vacation in the &ahamas. Additional pro#ected costs are F!$+22 for insurance$ and F+ per service call for materials and supplies. Their service calls would be priced at F'2 per unit$ plus any parts costs <parts will not be inventoried$ but purchased from local parts outlets?. A. 8hat is the accounting cost function for this business <ignoring parts?D &. 1. 8hat is the economic cost function for this businessD 8hat is the economic brea"even number of units for this operationD <Assume a F'2 price and ignore interest costs associated with the timing of the lease payments.?

ANS: A. The accounting cost function is: Total Accounting 1ost : T1A : 3ixed leasing plus insurance costs H >ariable materials plus supplies costs

: F+$222 H F!$+22 H F+9 : F.$+22 H F+9 &. The economic cost function is: Total 5conomic 1ost : Summer employment opportunity cost H T1 A : '<12$222? H F.$+22 H F+9 : F'.$+22 H F+9 1. The economic brea"even point is reached when: 9: : : 1$+22 service calls 1!. Pro#it Contri$"tion Analysis. San 3rancisco*s =ier 0$ (nc.$ sells souvenir T-shirts at a price of F!+. 6f this amount$ F1+ is profit contribution. =ier 0 is considering differentiating its product from several other competitors by using higher -uality T-shirts. oing so would increase unit cost by F!.+2 per shirt. 1urrent monthly profits are F12$222 on !$+22 unit sales. A. Assuming average variable costs are constant at all output levels$ what is 381*s total cost function before the proposed changeD &. 1. 8hat will the total cost function be if higher -uality t-shirts are usedD Assume shirt prices remain stable at F!+. 8hat percentage increase in sales would be necessary to maintain current profit levelsD

ANS: A. 3rom the definition of profit contribution$ on a per unit basis: =rofit contribution : = - A>1 F1+ : F!+ - A>1 A>1 : F12 per unit Total fixed cost for 381 can be calculated as follows: : TJ - T1 : TJ - T>1 - T31 : <= 9? - <A>1 9? - T31 F12$222 : F!+<!$+22? - F12<!$+22? - T31 F12$222 : F'.$+22 - T31 T31 : F!.$+22 Therefore$ the total cost function is: T1 : T31 H <A>1 9? T1 : F!.$+22 H F129 &. &y using higher -uality T-shirts$ variable cost would increase by F!.+2 while fixed costs remain the same. The new total cost function would be: T1 : F!.$+22 H F129 H F!.+29 T1 : F!.$+22 H F1!.+29 1. The new number of T-shirt sales necessary to maintain current profit levels would be: : <= 9? - <A>1 9? - T31 F12$222 : F!+9 - F1!.+29 - F!.$+22 1!.+9 : '.$+22 9 : '$222 =ercentage increase in 9 : : 2.! or !2M.

Thus$ a !2M increase in deliveries would be needed to maintain current profit levels. 1'. Pro#it Contri$"tion Analysis. &en @aden Jugs$ (nc.$ sells hand-made cotton rugs to tourists at a price of F+2. 6f this amount$ F)2 is profit contribution. &en @aden is considering an attempt to differentiate his product from several other competitors by using high -uality natural herb dyes. oing so would increase &en @aden*s unit cost by F1+ per rug. 1urrent annual profits are F'+$222 on 1$222 rug sales. A. Assuming average variable costs are constant at all output levels$ what is &en @aden*s total cost function before the proposed changeD &. 1. 8hat will the total cost function be if high -uality natural herb dyes are usedD Assume rug prices remain stable at F+2. 8hat percentage increase in sales would be necessary to maintain current profit levelsD

ANS:

A. 3rom the definition of profit contribution we "now that on a per unit basis: =rofit contribution : = - A>1 F)2 : F+2 - A>1 A>1 : F12 per unit Total fixed cost for &en @aden can be calculated as follows: : TJ - T1 : TJ - T>1 - T31 : <= 9? - <A>1 9? - T31 F'+$222 : F+2<1$222? - F12<1$222? - T31 F'+$222 : F)2$222 - T31 T31 : F+$222 Therefore$ the total cost function is: T1 : T31 H <A>1 9? T1 : F+$222 H F129 &. &y using high -uality natural herb dyes$ &en @aden*s variable cost would increase by F1+ while its fixed costs remain the same. &en @aden*s new total cost function would be: T1 : F+$222 H F129 H F1+9 T1 : F+$222 H F!+9 1. The new number of rug sales necessary to maintain current profit levels would be: : <= 9? - <A>1 9? - T31 F'+$222 : F+29 - F!+9 - F+$222 !+9 : )2$222 9 : 1$,22 =ercentage increase in 9 : : 2., or ,2M.

Thus$ a ,2M increase in rug sales would be needed to maintain current profit levels. 1). Pro#it Contri$"tion Analysis. Nathy*s &a"ery is a local full-service ba"ery in 6maha$ Nebras"a. Nathy sells loaves of wheat bread for F' a loaf. 6f this amount$ F1.+2 is profit contribution. She is considering an attempt to differentiate her shop from several other competitors by only producing a special rice bread for customers allergic to wheat. oing so would increase her unit cost by +2K per rice loaf. 1urrent monthly profits are F)22 on /22 unit sales. A. Assuming average variable costs are constant at all output levels$ what is Nathy*s total cost function before the proposed changeD &. 1. 8hat will the total cost function be if rice loafs are producedD Assume rice loaf prices remain stable at F'. 8hat percentage increase in sales would be necessary to maintain current profit levelsD

ANS:

A. 3rom the definition of profit contribution we "now that on a per unit basis: =rofit contribution : = - A>1 F1.+2 : F' - A>1 A>1 : F1.+2 per unit Total fixed cost for Nathy*s can be calculated as follows: : TJ - T1 : TJ - T>1 - T31 : <= 9? - <A>1 9? - T31 F)22 : F'</22? - F1.+</22? - T31 F)22 : F1$!22 - T31 T31 : F/22 Therefore$ the total cost function is: T1 : T31 H <A>1 9? T1 : F/22 H F1.+29 &. &y producing rice loafs$ Nathy*s variable cost would increase by +2K while its fixed costs remain the same. Nathy*s new total cost function would be: T1 : F/22 H F1.+29 H F2.+29 T1 : F/22 H F!9 1. The new number of loaves necessary to maintain current profit levels would be: : <= 9? - <A>1 9? - T31 F)22 : F'9 - F!9 - F/22 9 : 1$!22 =ercentage increase in 9 : : 2.+2 or +2M.

Thus$ a +2M increase in rice loaves over wheat loaves would be needed to maintain current profit levels. 1+. De%ree o# Operatin% Le!era%e. yna@inear$ @td.$ produces digital-to-analog converters for compact dis" players used by radio stations and audio enthusiasts. (t is contemplating an expansion into the moderately-priced home audio mar"et by producing a 1 player that would sell at a price of F'22. The production of each 1 player would re-uire F122 in materials$ and '..+ hours of labor at the rate of F!2 per hour for wages and fringe benefits plus variable overhead tied to labor. 5nergy$ supervisory and other variable overhead costs would amount to F+2 per unit. The accounting department has derived an allocated fixed overhead charge of F!+ per 1 player <at a pro#ected volume of 1)$222 units? to account for the expected increase in fixed costs. A. 8hat is yna@inear*s brea"even sales volume <in units? for home audio 1 playersD &. 1alculate the degree of operating leverage at a pro#ected volume of 1)$222 units and explain what the 6@ means.

ANS: A. The brea"even level of output is

9: : : : )$,,. units &. The e-uation for calculating the degree of operating leverage is: 6@ : 8here 6@ is the degree of operating leverage$ 9 is output$ and all other variables are as before. Therefore$ 6@ at 9 : 1)$222 is: 6@ : : : 1.+ A 6@ of 1.+ means that following a 1M change in output$ profits would be expected to change by 1.+M. 1,. De%ree o# Operatin% Le!era%e. Ceat Tamers$ (nc.$ of &end$ 6regon produces special heat-resistant boots used primarily by firefighters$ smo"e-#umpers and steelwor"ers. (t is contemplating an expansion into the heat resistant leather mar"et charging a price of F1+2 per pair of boots. The production of each pair of boots would re-uire F,2 in materials$ and 1.+ hours of labor at the rate of F!2 per hour. 5nergy$ supervisory and other variable overhead costs would amount to F!+ per unit. The accounting department has derived an allocated fixed overhead charge of F'2 per pair of boots <at a pro#ected volume of !/2$222 pairs? to account for the expected increase in fixed costs. A. 8hat is Ceat Tamers* brea"even sales volume <in pairs? for heat-resistant bootsD &. 1alculate the degree of operating leverage at a pro#ected volume of !/2$222 units and explain what the 6@ means.

ANS: A. The brea"even level of output is 9: : : : !)2$222 units

&.

The e-uation for calculating the degree of operating leverage is: 6@ : 8here 6@ is the degree of operating leverage$ 9 is output$ and all other variables are as before. Therefore$ 6@ at 9 : !/2$222 is: 6@ : : :. A 6@ of . means that following a 1M change in output$ profits would be expected to change by .M.

1.. De%ree o# Operatin% Le!era%e. (on Lenerating$ (nc.$ produces ion generators and control <detection? devices for industrial applications such as chemical labs. (t is contemplating an expansion into the home security mar"et by producing a smo"e detector based off of the same technology that would sell at a price of F+2. The production of each smo"e detector would re-uire F!2 in materials$ and 2.) hours of labor at the rate of F!+ per hour. 5nergy$ supervisory and other variable overhead costs would amount to F12 per unit. The accounting department has derived an allocated fixed overhead charge of F..+2 per smo"e detector <at a pro#ected volume of '22$222 units? to account for the expected increase in fixed costs. A. 8hat is (on Lenerating*s brea"even sales volume <in units? for smo"e detectorsD &. 1alculate the degree of operating leverage at a pro#ected volume of '22$222 units and explain what the 6@ means.

ANS: A. The brea"even level of output is 9: : : : !!+$222 units &. The e-uation for calculating the degree of operating leverage is: 6@ : where 6@ is the degree of operating leverage$ 9 is output$ and all other variables are as before. Therefore$ 6@ at 9 : 1)$222 is:

6@ : : :) A 6@ of ) means that following a 1M change in output$ profits would be expected to change by )M. 1/. M"ltiplant Operation. Tasty Snac"s$ (nc.$ a regional snac" foods company <corn chips$ potato chips$ etc.? in the northeast$ is considering two alternative proposals for expansion into southeastern states. Alternative 1: 1onstruct a single plant in 1hattanooga$ Tennessee with a monthly production capacity of !+2$222 cases$ a monthly fixed cost of F!,+$222$ and a variable cost of F)+ per case. Alternative !: 1onstruct three plants$ one each in &irmingham$ Alabama$ Tallahassee$ 3lorida$ and 1harlotte$ North 1arolina$ with capacities of 122$222$ /2$222 and .2$222$ respectively$ and monthly fixed costs of F1/2$222$ F1+2$222$ and F1'+$222 each. >ariable costs would be only F)) per case because of lower distribution costs. To achieve these cost savings$ sales from each smaller plant would be limited to demand within its home state. The total estimated monthly sales volume of 1.+$222 cases in these three southeastern states is distributed as follows: .2$222 cases in 3lorida$ ,2$222 cases in North 1arolina$ and )+$222 cases in Alabama. A. Assuming a wholesale price of F+2 per case$ calculate the brea"even output -uantities for each alternative. &. At a wholesale price of F+2 per case in all states$ and assuming sales at the pro#ected levels$ which alternative expansion scheme provides Tasty Snac"s with the highest profit per monthD (f sales increase to production capacities$ which alternative would prove to be more profitableD

1.

ANS: A. The brea"even output -uantity for the single plant alternative is: 9: : : +'$222 cases per month The brea"even output -uantities for the multiple plant alternative is: 9&irmingham : : '2$222 per month 9Tallahassee : : !+$222 cases per month

91harlotte : : !!$+22 cases per month Thus$ the firm-level brea"even -uantity for the multiple plant alternative would be: 9 : '2$222 H !+$222 H !!$+22 : ..$+22 cases per month =rovided that demand was distributed among the states in amounts e-ual to the brea"even -uantities for each individual plant. &. Single plant alternative: : TJ - T1 : =9 - T31 - A>1<9? : F+2<1.+$222? - F!,+$222 - F)+<1.+$222? : F,12$222 4ultiple plant alternative: : TJ - T1 : =9 - T31& - T31T - T311 - A>1<9? : F+2<1.+$222? - F1/2$222 - F1+2$222 - F1'+$222 - F))<1.+$222? : F+/+$222 4anagement would prefer the single plant alternative because of its greater profitability. 1. Single plant at full capacity: : TJ - T1 : =9 - T31 - A>1<9? : F+2<!+2$222? - F!,+$222 - F)+<!+2$222? : F0/+$222 4ultiple plants at full capacity: : TJ - T1 : =9 - T31& - T31T - T311 - A>1<9? : F+2<!+2$222? - F1/2$222 - F1+2$222 - F1'+$222 - F))<!+2$222? : F1$2'+$222 At pea" capacity$ management would prefer the multiple plant option because of its greater profitability.

10. M"ltiplant Operation. Nature*s Lreen$ (nc.$ a manufacturer of alfalfa tablets sold in health-food stores$ currently operates #ust outside of 4eno$ 1alifornia. Nature*s Lreen is considering two alternative proposals for expansion$ because it has run out of acreage to grow its organically-farmed alfalfa. (t has found the following sites where farmers are willing to supply organic alfalfa: Alternative 1: 1onstruct a single plant in &ig 1abin$ 6"lahoma with a monthly production capacity of +2$222 cases$ a monthly fixed cost of F!.+$222$ and a variable cost of F122 per case. Alternative !: 1onstruct three plants$ one each in 5udora$ Nansas$ Springfield$ 4issouri$ and Ton"awa$ 6"lahoma$ with capacities of !+$222$ !2$222 and 1+$222$ respectively$ and monthly fixed costs of F!22$222$ F1.+$222$ and F1,2$222 each. >ariable costs would be only F0+ per case because of lower distribution costs. To achieve these cost savings$ sales from each smaller plant would be limited to demand within its home state. The total estimated monthly sales volume of )0$222 cases in these three southeastern states is distributed as follows: !2$222 cases in Nansas$ 1+$222 cases in 4issouri$ and 1)$222 cases in 6"lahoma. A. Assuming a wholesale price of F1!2 per case$ calculate the brea"even output -uantities for each alternative. &. 1. Assuming sales at the pro#ected levels$ which alternative expansion scheme provides Nature*s Lreen with the highest profit per monthD (f sales increase to production capacities$ which alternative would prove to be more profitableD

ANS: A. The brea"even output -uantity for the single plant alternative is: 9: : : 1'$.+2 cases per month The brea"even output -uantities for the multiple plant alternative is: 95udora : : /$222 cases per month 9Springfield : : .$222 cases per month 9Ton"awa : : ,$)22 cases per month Thus$ the firm-level brea"even -uantity for the multiple plant alternative would be: 9 : /$222 H .$222 H ,$)22 : !1$)22 cases per month =rovided that demand was distributed among the states in amounts e-ual to the brea"even -uantities for each individual plant.

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Single plant alternative: : TJ - T1 : =9 - T31 - A>1<9? : F1!2<)0$222? - F!.+$222 - F122<)0$222? : F.2+$222 4ultiple plant alternative: : TJ - T1 : =9 - T315 - T31S - T31T - A>1<9? : F1!2<)0$222? - F!22$222 - F1.+$222 - F1,2$222 - F0+<)0$222? : F,02$222 4anagement would prefer the single plant alternative because of its greater profitability.

1.

Single plant at full capacity: : TJ - T1 : =9 - T31 - A>1<9? : F1!2<+2$222? - F!.+$222 - F122<+2$222? : F.!+$222 4ultiple plants at full capacity: : TJ - T1 : =9 - T315 - T31S - T31T - A>1<9? : F1!2<,2$222? - F!22$222 - F1.+$222 - F1,2$222 - F0+<,2$222? : F0,+$222 At pea" capacity$ management would prefer the multiple plant option because of its greater profitability.

!2. Learnin% C"r!e. 3ashionable esigns$ @td.$ plans to mar"et a new sports bla%er. &ased on information provided by the accounting department$ the company estimates fixed costs of F)2$222 per year and average variable costs at: A>1 : F1 H F2.2219 where A>1 is average variable cost <in dollars? and 9 is output measured in cases of output per year. A. 1alculate total cost and average total cost for the coming year at a pro#ected volume of 1!$222 units. &. An increase in wor"er productivity due to greater experience or learning during the course of the year resulted in a substantial cost saving for the company. 1alculate the effect of learning on average total cost if actual total cost was F!+2$222 at an actual volume of 1+$222 units.

ANS: A. The total variable cost function for the coming year is:

T>1 : A>1 9 : <F1 H F2.2219?9 : F19 H F2.2219! At a volume of 1!$222 units$ estimated total cost is: T1 : T31 H T>1 : F)2$222 H F19 H F2.2219! : F)2$222 H F1<1!$222? H F2.221<1!$222!? : F10,$222 5stimated average cost is: A1 : T1;9 : F10,$222;1!$222 : F1,.'' per unit &. 8ithout learning$ estimated total cost and average total cost at a volume of 1+$222 units are: T1 : F)2$222 H F1<1+$222? H F2.221<1+$222!? : F!/2$222 A1 : T1;9 : F!/2$222;1+$222 : F1/.,. per unit &ecause estimated average cost <without learning? has risen between 1!$222 and 1+$222 units <see part a?$ the company is operating in a range of decreasing returns to scale. (f actual total costs were F!+2$222 at a volume of 1+$222 units$ actual average total costs were: A1 : T1;9 : F!+2$222;1+$222 : F1,.,. per unit Therefore$ greater experience or learning has resulted in an average cost saving of F! per unit because: @earning effect : Actual A1 - 5stimated A1 : F1,.,. - F1/.,. : <F!? per unit Alternatively$ @earning rate : : : 12..M

!1. Learnin% C"r!e. Teddy &ear$ (nc.$ a rapidly growing manufacturer of high fashion children*s shoes$ plans to open a new production facility in &ethesda$ 4aryland. &ased on information provided by the accounting department$ the company estimates fixed costs of F+22$222 per year and average variable costs at: A>1 : F+ H F2.22219 where A>1 is average variable cost <in dollars? and 9 is output measured in cases of output per year. A. 1alculate total cost and average total cost for the coming year at a pro#ected volume of +2$222 pairs of shoes. &. An increase in wor"er productivity due to greater experience or learning during the course of the year resulted in a substantial cost saving for the company. 1alculate the effect of learning on average total cost if actual total cost was F1$2/2$222 at an actual volume of ,2$222 pairs of shoes.

ANS: A. The total variable cost function for the coming year is: T>1 : A>1 9 : <F+ H F2.22219?9 : F+9 H F2.22219! At a volume of +2$222 units$ estimated total cost is: T1 : T31 H T>1 : F+22$222 H F+9 H F2.22219! : F+22$222 H F+<+2$222? H F2.2221<+2$222!? : F1$222$222 5stimated average cost is: A1 : T1;9 : F1$222$222;+2$222 : F!2 per pair &. 8ithout learning$ estimated total cost and average total cost at a volume of ,2$222 pairs are: T1 : F+22$222 H F+<,2$222? H F2.2221<,2$222!? : F1$1,2$222 A1 : T1;9 : F1$1,2$222;,2$222 : F10.'' per pair &ecause estimated average cost <without learning? has fallen between +2$222 and ,2$222 units <see part a?$ the company is operating in a range of increasing returns to scale. (f actual total costs were F1$2/2$222 at a volume of ,2$222 pairs$ actual average total costs were: A1 : T1;9

: F1$2/2$222;,2$222 : F1/ per pair Therefore$ greater experience or learning has resulted in an average cost saving of F1.'' per pair because: @earning effect : Actual A1 - 5stimated A1 : F1/ - F10.'' : <F1.''? per pair Alternatively$ @earning rate : : : ,.0M !!. Economies o# Scale. Tucson Timing$ (nc.$ has #ust completed a study of wee"ly production costs during the past year for its premium -uality$ automotive strobe timing light$ the 3lash Lun ((. &y regressing total variable costs on output the firm estimated the following e-uation. T>1 : F'2 H F1!+9 - F19! <1+? <'? <2.+?

J! : 02M$ S55 : 12 Cere total variable cost <T>1? is expressed in thousands of dollars and 9 is in thousands of strobe timing lights <units? produced per wee". Numbers in parentheses are the standard errors of the coefficients. A. 5stimate total variable cost and average variable cost per wee" for the coming year at a pro#ected volume of 12$222 units per wee". &. uring this period$ the company experienced an unexpected interruption in supplier deliveries$ and unexpected increases in the cost of labor and materials. (f actual average variable costs were F122 per unit at an average actual volume of 1+$222 units per wee"$ calculate the separate influences on average variable cost of lost economies of scale and the unexpected input cost increases.

ANS: A. 5stimated total variable cost and average variable cost at a pro#ected volume of 12$222 units are: T 1 : F'2 H F1!+9 - F19! : F'2 H F1!+<12? - <12!? : F1$1/2<222? per wee" A 1 : T>1;9 : F1$1/2;12 : F11/ per unit

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5stimated total variable cost and average variable cost at a volume of 1+$222 units are: T 1 : F'2 H F1!+<1+? - F1<1+!? : F1$,/2<222? per wee" A 1 : T>1;9 : F1$,/2;1+ : F11! per unit Thus$ the pro#ected A>1 decrease due to increased economies of scale as output rose from 12$222 to 1+$222 per wee" is F, because: (ncreased economies of scale effect : A 1 O 12$222 units - A 1 O 1+$222 units : F11/ - F11! : F, per unit &ecause actual A>1 : F122 at a volume of 1+$222 units per wee"$ decreases in the cost of labor and materials caused A>1 to decrease by F1! over the pro#ected level: : =ro#ected A 1 - Actual A>1 : F11! - F122 : F1! per unit Therefore$ the overall F1/ A>1 decrease reflects the effects of both increased economies of scale <F,? and the decrease in input costs <F1!?.

!'. Economies o# Scale. 8indy 4anes$ (nc.$ has #ust completed a study of wee"ly production costs during the past year for its compact hand-held hair dryer. &y regressing total variable costs on output the firm estimated the following e-uation. T>1 : F1+ H F+9 - F2.219! <)? <!? <2.22+?

J! : /'.+M$ S55 : 1/ Cere total variable cost <T>1? is expressed in thousands of dollars and 9 is in thousands of hand-held hair dryers <units? produced per wee". Numbers in parentheses are the standard errors of the coefficients. A. 5stimate total variable cost and average variable cost per wee" for the coming year at a pro#ected volume of +2$222 units per wee". &. uring this period$ the company experienced an unexpected interruption in supplier deliveries$ and unexpected increases in the cost of labor and materials. (f actual average variable costs were F).'2 per unit at an average actual volume of .+$222 units per wee"$ calculate the separate influences on average variable cost of lost economies of scale and the unexpected input cost increases.

ANS: A. 5stimated total variable cost and average variable cost at a pro#ected volume of +2$222 units are: T 1 : F1+ H F+9 - F2.219!

: F1+ H F+<+2? - F2.21<+2!? : F!)2<222? per wee" A 1 : T>1;9 : F!)2;+2 : F)./2 per unit &. 5stimated total variable cost and average variable cost at a volume of .+$222 units are: T 1 : F1+ H F+<.+? - F2.21<.+!? : F'''..+<222? or <F'''$.+2? per wee" A 1 : T>1;9 : F'''..+;.+ : F).)+ per unit Thus$ the pro#ected A>1 increase due to increased economies of scale as output rose from +2$222 to .+$222 per wee" is F2.'+ because: (ncreased economies of scale effect : A 1 O +2$222 units - A>1 O .+$222 units : F)./2 - F).)+ : F2.'+ per unit &ecause actual A>1 : F).'2 at a volume of .+$222 units per wee"$ decreases in the cost of labor and materials caused A>1 to decrease by F2.1+ over the pro#ected level: : =ro#ected A 1 - Actual A>1 : F).)+ - F).'2 : F2.1+ per unit Therefore$ the overall F2.+2 A>1 decrease reflects the effects of both increased economies of scale <F2.'+? and the decrease in input costs <F2.1+?. !). Cost Estimation. Natural Las$ (nc.$ has #ust completed a cost study of its natural gas production operation. &y regressing total variable costs <in F222? per wee" on gas output$ the following e-uation was estimated: Total variable cost : F,$+22 H F2.!+9 - F2.2221!+9! <+$222? <2.1!? <2.2222+?

Cere 9 is natural gas production in thousand cubic feet <units? and the numbers in parentheses are the standard errors of the coefficients. The J! for the e-uation is /+M$ and the standard error of the estimate is +2 for the wee"ly observations over a two-year period. A. (nterpret the coefficient of determination <J!?. &. 1. (f volume averages /$222 units per wee"$ calculate the range within which we would expect to find actual total variable and average variable costs with 0+M confidence. 1alculate and interpret relevant t statistics.

. Are Natural Las* average variable costs per unit increasing as output expandsD ANS: A. 1oefficient of determination : J! : /+M$ meaning that /+M of total variable cost variation is

explained by the -uadratic cost model. The remaining 1+M of cost variation is unexplained. &. 8ith an average volume of /$222 units per wee"$ the estimated value for total variable costs is: T 1 : F,$+22 H F2.!+9 - F2.2221!+9! : F,$+22 H F2.!+</$222? - 2.2221!+</$222!? : F+22<222? 8ith a standard error of the estimate : S55 : +2$ the 0+M confidence interval for actual T>1 is: T>1 : T 1 ! <S55? : F+22 !<F+2? : F)22<222? to F,22<222? Liven these data$ the relevant estimate for average variable cost is: A 1:T 1 : F+22<222?;/$222<222? : F2.2,!+ or ,.!+K per unit And the relevant 0+M confidence interval is: A 1: : F2.2+ to F2.2.+ 1. Note that F,$+22 is not an estimate of fixed costs per month because the analysis included only variable costs. t statistics for each output variable can also be calculated to test: C2:b1 : 2P and C2:b! : 2. 3or b1: t : 3or b!: t : : !.2/ : !.+ to

Therefore$ both coefficients are statistically significant at the 0+M confidence level <i.e.$ t 7 !?$ and a -uadratic total variable cost function is suggested. . No. Liven the negative sign and statistical significance of the -uadratic variable coefficient$ average variable costs are falling as output expands. &ecause average fixed costs always decline as output expands$ average total costs for Natural Las are also declining as output expands. This implies that Natural Las is currently en#oying increasing returns to scale and the elasticity of cost with respect to output will be less than one$ 1 Q 1. !+. Cost Estimation. Campshire Textiles$ (nc.$ has #ust completed a cost study of its moire taffeta production facility. &y regressing total variable costs per wee" on cloth output$ one of their financial analysts estimated the following e-uation: Total variable cost : F'2$222 H F)9 - F2.22!9! <!2$222? <1.+? <2.222/?

Cere 9 is moire taffeta cloth production in s-uare yards and the numbers in parentheses are the standard errors of the coefficients. The J! for the e-uation was /2M$ and the standard error of the estimate was 1+2 for the wee"ly observations over a two-year period. A. (nterpret the coefficient of determination <J!?. &. 1. (f volume averages !$+22 yards per wee"$ calculate the range within which we would expect to find actual total variable and average variable costs with 0+M confidence. 1alculate and interpret relevant t-statistics.

. Are Campshire Textiles* average variable costs per unit increasing as output expandsD ANS: A. 1oefficient of determination : J! : /2M$ meaning that /2M of total variable cost variation is explained by the -uadratic cost model. The remaining !2M of cost variation is unexplained. &. 8ith an average volume of !$+22 yards per wee"$ the estimated value for total variable costs is: T 1 : F'2$222 H F)9 - F2.22!9! : F'2$222 H F)<!$+22? - 2.22!<!$+22 !? : F!.$+22 8ith a standard error of the estimate : S55 : 1+2$ the 0+M confidence interval for actual T>1 is: T>1 : T 1 ! <S55? : F!.$+22 !<F1+2? : F!.$!22 to F!.$/22 Liven these data$ the relevant estimate for average variable cost is: A 1 : T 1;9 : F!.$+22;!$+22 : F11 per yard And the relevant 0+M confidence interval is: A 1: to

: F12.// to F11.1! per yard 1. Note that F'2$222 is not an estimate of fixed costs per month because the analysis included only variable costs. t statistics for each output variable can also be calculated to test: C2:b1 : 2P and C2:b! : 2. 3or b1: t : : !.,.

3or b!: t :

: !.+

Therefore$ both coefficients are statistically significant at the 0+M confidence level <i.e.$ t 7 !?$ and a -uadratic total variable cost function is suggested. . No$ given the negative sign and statistical significance of the -uadratic variable coefficient$ average variable costs are falling as output expands. &ecause average fixed costs always decline as output expands$ average total costs for Campshire Textiles are also declining as output expands. This implies that Campshire Textiles is currently en#oying increasing returns to scale and the elasticity of cost with respect to output will be less than one$ 1 Q 1.