# Managerial Economics Study Set 11

## Quiz 8 :Cost Analysis and Estimation

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Multiplant Operation. Appalachia Beverage Company, Inc. is considering alternative proposals for expansion into the Midwest. Alternative 1: Construct a single plant in Indianapolis, Indiana, with a monthly production capacity of 300,000 cases, a monthly fixed cost of $262,500, and a variable cost of$3.25 per case. Alternative 2: Construct three plants, one each in Muncie, Indiana; Normal, Illinois; and Dayton, Ohio, with capacities of 120,000, 100,000, and 80,000, respectively, and monthly fixed costs of $120,000,$110,000, and $95,000 each. Variable costs would be only$3 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 200,000 cases in these three Midwestern states is distributed as follows: 80,000 cases in Indiana, 70,000 cases in Illinois, and 50,000 cases in Ohio. A. Assuming a wholesale price of $5 per case, calculate the breakeven output quantities for each alternative. B. At a wholesale price of$5 per case in all states, and assuming sales at the projected levels, which alternative expansion scheme provides Appalachia with the highest profit per month? C. If sales increase to production capacities, which alternative would prove to be more profitable?
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Appalachia Beverage Company Inc. has two alternatives:
Alternative 1 : Construct a single plant with capacity of 300,000 cases, a monthly fixed cost of $262,500 and a variable cost of$3.25 per case.
Alternative 2 : Construct 3 plants with capacities of 120,000; 100,000 and 80,000 with monthly fixed cost of $120,000,$110,000 and $95,000 and variable cost$3 per case.
(A)Breakeven level of output is the quantity of output where the total revenue equals total cost. The break-even quantity can be calculated using the formula:
Alternative 1:
Where Q=Quantity, VC=variable cost, FC=fixed cost, TR=total revenue, TC=Total cost, price.
The breakeven quantity where total revenue is equal to total cost is 150000 cases.
Alternative 2:
The breakeven quantity where total revenue is equal to total cost is 162500 cases.
(B)At wholesale price of $5 and sales at 200,000 , the profits under two alternatives are: Similarly the profit for alternative 2 is: The profit for alternative one and two are$87500 and $75000 respectively. Option 1 gives greater profits than the second one. (C)If sales increase to production capacity of 300,000, then profit for both alternatives would be: Similarly the profit for alternative 2 is: The profit for alternative one and two are$262500 and $275000 respectively and hence multiple plant, option 2, should be chosen. Tags Choose question tag Cost Elasticity. Power Brokers, Inc. (PBI), a discount brokerage firm, is contemplating opening a new regional office in Providence, Rhode Island. An accounting cost analysis of monthly operating costs at a dozen of its regional outlets reveals average fixed costs of$4,500 per month and average variable costs of AVC = $59 -$0.006 Q where AVC is average variable costs (in dollars) and Q is output measured by number of stock and bond trades. A typical stock or bond trade results in $100 gross commission income, with PBI paying 35 percent of this amount to its sales representatives. A. Estimate the trade volume necessary for PBI to reach a target return of$7,500 per month for a typical office. B. Estimate and interpret the elasticity of cost with respect to output at the trade volume found in part A.
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The power brokers Inc. has a fixed cost $4,500 per month and average variable cost of ($59 - 0.006Q). The commission on stock is $100 per trade with 35% to sales representative, which mean$65 per trade.
(A)The quantity at which a profit of $7500 is generated can be calculated by equating the difference in total revenue and total cost to profit as below: By putting profit=$7500, the quantity can be calculated:
On solving the above equation:
As the quantity cannot be in negative, the answer is 1,000.
(B)The point cost elasticity is the relation between cost and output. The point cost elasticity is defined as:
Where C=total cost, MC=marginal cost, Q=Quantity
It is given that AVC
Therefore cost elasticity at Q=1000 is:
This explains that if the output increases by 1%, there is 0.817% increase in cost. This is a situation of economies of scale and the firm can further expand its output level.

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What is the relation between production functions and cost functions? Be sure to include in your dis cussion the effect of competitive conditions in input factor markets.
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The production function explains the relationship between input and output. On the other hand, cost function explains the relationship between cost and output. As the output increases, the cost function and production function gives increasing returns to scale (output greater than input) and after sometime these functions start giving decreasing returns to scale (output less than input and cost greater than output). Therefore, the costs function and production function has a direct relationship.

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The president of a small firm has been complaining to the controller about rising labor and material costs. However, the controller notes that average costs have not increased during the past year. Is this possible?
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Learning Curves. The St. Thomas Winery plans to open a new production facility in the Napa Valley of California. Based on information provided by the accounting department, the company estimates fixed costs of $250,000 per year and average variable costs of AVC =$10 + $0.01 Q where AVC is average variable cost (in dollars) and Q is output measured in cases of output per year. A. Estimate total cost and average total cost for the coming year at a projected volume of 4,000 cases. B. An increase in worker productivity because of greater experience or learning during the course of the year resulted in a substantial cost saving for the company. Estimate the effect of learning on average total cost if actual total cost was$522,500 at an actual volume of 5,000 cases.
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Cost-Volume-Profit Analysis. Textbook publishers evaluate market size, the degree of competition, expected revenues, and costs for each prospective new title. With these data in mind, they estimate the probability that a given book will reach or exceed the breakeven point. If the publisher estimates that a book will not exceed the breakeven point based upon standard assumptions, they may consider cutting production costs by reducing the number of illustrations, doing only light copy editing, using a lower grade of paper, or negotiating with the author to reduce the royalty rate. To illustrate the process, consider the following data: Fixed costs of $100,000 can be estimated quite accurately. Variable costs are linear and set by contract. List prices are variable, but competition keeps prices within a narrow range. Variable costs for the proposed book are$92 a copy, and the expected wholesale price is $100. This means that each copy sold provides the publisher with an$8 profit contribution. A. Estimate the volume necessary to reach a breakeven level of output. B. How many textbooks would have to be sold to generate a profit contribution of $20,000? C. Calculate the economic profit contribution or loss resulting from the acceptance of a book club offer to buy 3,000 copies directly from the publisher at a price of$77 per copy. Should the offer be accepted?
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Suppose the Big Enchilada restaurant has been offered a binding 1-year lease agreement on an attractive site for $5,200 per month. Before the lease agreement has been signed, what is the incremental cost per month of site rental? After the lease agreement has been signed, what is the incremental cost per month of site rental? Explain. Essay Answer: Tags Choose question tag Cost Curves. Indicate whether each of the following involves an upward or downward shift in the long-run average cost curve or, instead, involves a leftward or rightward movement along a given curve. Also indicate whether each will have an increasing, decreasing, or uncertain effect on the level of average cost. A. A rise in wage rates. B. A decline in output. C. An energy-saving technical change. D. A fall in interest rates. E. An increase in learning or experience. Essay Answer: Tags Choose question tag Accounting and Economic Costs. Three graduate business students are considering operating a fruit smoothie stand in the Harbor Springs, Michigan, resort area during their summer break. This is an alternative to summer employment with a local firm, where they would each earn$6,000 over the 3-month summer period. A fully equipped facility can be leased at a cost of $8,000 for the summer. Additional projected costs are$1,000 for insurance and $3.20 per unit for materials and supplies. Their fruit smoothies would be priced at$5 per unit. A. What is the accounting cost function for this business? B. What is the economic cost function for this business? C. What is the economic breakeven number of units for this operation? (Assume a $5 price and ignore interest costs associated with the timing of lease payments.) Essay Answer: Tags Choose question tag Profit Contribution. Angelica Pickles is manager of a Quick Copy franchise in White Plains, New York. Pickles projects that by reducing copy charges from 5¢ to 4¢ each, Quick Copy's$600-per-week profit contribution will increase by one-third. A. If average variable costs are 2¢ per copy, calculate Quick Copy's projected increase in volume. B. What is Pickles' estimate of the arc price elasticity of demand for copies?
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Do operating strategies of average cost minimization and profit maximization always lead to identical levels of output?
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Incremental Cost. South Park Software, Inc. produces innovative interior decorating software that it sells to design studios, home furnishing stores, and so on. The yearly volume of output is 15,000 units. Selling price and costs per unit are as follows: ` Management is evaluating the possibility of using the Internet to sell its software directly to consumers at a price of $300 per unit. Although no added capital investment is required, additional shipping and handling costs are estimated as follows: Calculate the incremental profit that South Park would earn by customizing its instruments and marketing them directly to end users. Essay Answer: Tags Choose question tag Assume that 2 years ago, you purchased a new Jeep Wrangler SE 4WD with a soft top for$16,500 using 5-year interest-free financing. Today, the remaining loan balance is $9,900 and your Jeep has a trade-in value of$9,500. What is your opportunity cost of continuing to drive the Jeep? Discuss the financing risk exposure of the lender.
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Cost Relations. Determine whether each of the following is true or false. Explain why. A. Average cost equals marginal cost at the minimum efficient scale of plant. B. When total fixed cost and price are held constant, an increase in average variable cost will typically cause a reduction in the breakeven activity level. C. If ? C 1, diseconomies of scale and increasing average costs are indicated. D. When long-run average cost is decreasing, it can pay to operate larger plants with some excess capacity rather than smaller plants at their peak efficiency. E. An increase in average variable cost always increases the degree of operating leverage for firms making a positive net profit.
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What advantages or disadvantages do you see in using current costs for tax and stockholder reporting purposes?
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With traditional medical insurance plans, workers pay a premium that is taken out of each paycheck and must meet an annual deduction of a few hundred dollars. After that, insurance picks up most of their health-care costs. Companies complain that this gives workers little incentive to help control medical insurance costs, and those costs are spinning out of control. Can you suggest ways of giving workers better incentives to control employer medical insurance costs?
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Will firms in industries in which high levels of output are necessary for minimum efficient scale tend to have substantial degrees of operating leverage?
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Degree of Operating Leverage. Untouchable Package Service (UPS) offers overnight package delivery to Canadian business customers. UPS has recently decided to expand its facilities to better satisfy current and projected demand. Current volume totals 2 million packages per week at a price of $12 each, and average variable costs are constant at all output levels. Fixed costs are$3 million per week, and profit contribution averages one-third of revenues on each delivery. After completion of the expansion project, fixed costs will double, but variable costs will decline by 25 percent. A. Calculate the change in UPS's weekly breakeven output level that is due to expansion. B. Assuming that volume remains at 2 million packages per week, calculate the change in the degree of operating leverage that is due to expansion. C. Again assuming that volume remains at 1 million packages per week, what is the effect of expansion on weekly profit?
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Southwest Airlines offers four flights per weekday from Cleveland, Ohio, to Tucson, Arizona. If adding a fifth flight per weekday would cost $15,000 per flight, or$110 per available seat, calculate the incremental costs borne by Southwest following a decision to go ahead with a fifth flight per day for a minimal 60-flight trial period. What is the marginal cost? In this case, is incremental cost or marginal cost relevant for decision-making purposes?