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Chapter 3: Problem 10

Give an example of how a manager can decrease variable costs while increasing fixed costs.

Short Answer

Expert verified
Invest in automation to reduce variable labor costs and increase fixed asset costs.

Step by step solution

01

Understanding Variable and Fixed Costs

Variable costs are expenses that change in proportion to the business activity level, such as raw materials and direct labor costs. Fixed costs, on the other hand, remain constant regardless of the business activity level, such as rent and salaries of permanent staff.
02

Analyzing Cost-Structure Changes

To decrease variable costs while increasing fixed costs, consider adopting strategies that replace variable-cost-based expenses with fixed-cost ones. This usually involves making larger upfront investments or commitments.
03

Example Scenario

Imagine a factory that manufactures widgets and pays workers per piece produced (a variable cost). The manager decides to invest in an automated machine that can manufacture widgets. The purchase and maintenance of the machine become a fixed cost, but this investment significantly reduces the variable labor costs.
04

Evaluating the Financial Impact

The initial cost of the machine adds to the fixed costs, but the reduction in wages per widget (variable costs) leads to overall cost savings in high production scenarios. This reallocation can improve efficiency and predictability of expenses.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Variable Costs
Variable costs are dynamic. They change based on how much a business is producing or selling. These costs include things like raw materials, packaging, and direct labor that fluctuate directly with production output.
For example, if you own a bakery, the more cakes you bake, the more flour, eggs, and sugar you need. Hence, your costs go up with every cake.
  • Raw Materials: The basic ingredients or supplies that go into making a product. For instance, fabric for clothes or metal for cars.
  • Direct Labor: Wages paid to workers who add value to the product, like assembly line workers in a factory.
Understanding variable costs helps managers plan production and make decisions on pricing and profit margins. If you can reduce variable costs, you can lower the overall cost needed to produce each unit, thereby increasing profit.
Fixed Costs
Fixed costs are constant, unwavering expenses that don't change with the level of output. This makes them predictable and easier to manage.
These include rent, salaries, and insurance  expenses paid no matter how many units are produced or sold.
  • Rent: The monthly payment for a business space or manufacturing facility.
  • Salaries: Regular wages for staff, like management or administrative roles, that don't directly vary with production.
The stability of fixed costs makes them a core consideration in budgeting. Increasing fixed costs deliberately, such as by investing in technology, can innovate processes and potentially drive down other costs in the long run.
Automation in Manufacturing
Automation is transforming industries by using machinery or technology to perform tasks traditionally done by people.
This shift not only increases efficiency but often reduces the variable costs associated with labor. For instance, a company might use robots to assemble cars rather than employing large numbers of workers.
  • Precision: Machines work with high accuracy, reducing errors and wastage.
  • Continuous Work: Automated systems can operate 24/7, increasing production capacity.
By converting labor costs into technology investments, businesses can improve output and consistency. The initial investment might be high, but the long-term savings and productivity can potentially outweigh the cost.
Cost Structure Changes
Switching from a variable-cost-heavy model to one with more fixed costs is called a cost structure change.
This typically happens when a business invests in automation or infrastructure to gain long-term financial benefits. For example, buying an automated manufacturing line leads to higher fixed costs but results in lower variable costs related to labor.
  • Long-Term Planning: Involves predicting how these changes will impact future profits and expenses.
  • Considerations: Includes the upfront cost, the time needed to break even, and the expected lifespan of the new system or equipment.
Such strategic changes must be carefully analyzed. They can offer stability in costs and potential competitive advantage by improving efficiency and reducing reliance on fluctuating labor markets.

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Most popular questions from this chapter

Monroe Classical Music Society is a not-for-profit organization that brings guest artists to the community's greater metropolitan area. The Music Society just bought a small concert hall in the center of town to house its performances. The mortgage payments on the concert hall are expected to be \(\$ 2,000\) per month. The organization pays its guest performers \(\$ 1,000\) per concert and anticipates corresponding ticket sales to be \(\$ 2,500\) per event. The Music Society also incurs costs of approximately \(\$ 500\) per concert for marketing and advertising. The organization pays its artistic director \(\$ 50,000\) per year and expects to receive \(\$ 40,000\) in donations in addition to its ticket sales. 1\. If the Monroe Classical Music Saciety just breaks even, how many concerts does it hold? 2\. In addition to the organization's artistic director, the Music Society would like to hire a marketing director for \(\$ 40,000\) per year. What is the breakeven point? The Music Society anticipates that the addition of a marketing director would allow the organization to increase the number of concerts to 60 per year. What is the Music Society's operating income/(loss) if it hires the new marketing director? 3\. The Music Society expects to receive a grant that would provide the organization with an additional \(\$ 20,000\) toward the payment of the marketing director's salary. What is the breakeven point if the Music Society hires the marketing director and receives the grant?

Pure Water Products produces two types of water fill ters. One attaches to the faucet and cleans all water that passes through the faucet. The other is a pitcher-cum-filiter that only purifies water meant for drinking. The unit that attaches to the faucet is sold for \(\$ 80\) and has variable costs of \(\$ 20\) The pitcher-cum-fititer sells for S90 and has variable costs of \(\$ 25\) Pure Water sells two faucet models for every three pitchers sold. Fixed costs equal S945,000 1\. What is the breakeven point in unit sales and dollars for each type o ffilter at the current sales mix? 2\. Pure Water is considering buying new production equipment. The new equipment will increase fixed cost by \(\$ 181,400\) per year and will decrease the variable cost of the faucet and the pitcher units by \(\$ 5\) and S9 respectively. Assuming the same sales mix, how many of each trype of filter does Pure Water need to sell to break even? 3\. Assuming the same sales mix, at what total sales level would Pure Water be indifferent between using the old equipment and buying the new production equipment? If total sales are expected to be 30,000 units, should Pure Water buy the new production equipment?

\((\mathrm{CMA},\) adapted) Technology Solutions sells a ready-to-use software product for small businesses. The current selling price is \(\$ 300 .\) Projected operating income for 2011 is \(\$ 490,000\) based on a sales volume of 10,000 units. Variable costs of producing the software are \(\$ 120\) per unit sold plus an additional cost of \(\$ 5\) per unit for shipping and handling. Technology Solutions annual fixed costs are \(\$ 1,260,000\) 1\. Calculate Technology Solutions breakeven point and margin of safety in units. 2\. Calculate the company's operating income for 2011 if there is a \(10 \%\) increase in unit sales. 3\. For 2012 , management expects that the per unit production cost of the software will increase by \(30 \%\), but the shipping and handling costs per unit will decrease by \(20 \%\). Calculate the sales revenue Technology Solutions must generate for 2012 to maintain the current year's operating income if the selling price remains unchanged, assuming all other data as in the original problem.

Describe the assumptions underlying CVP analysis.

The Super Donut owns and operates six doughnut outlets in and round Kansas City. You are given the following corporate budget data for next year: $$\begin{array}{ll}\text { Revenues } & \$ 10,000,000 \\ \text { Fixed costs } & \$ 1,800,000 \\\\\text { Variable costs } & \$ 8,000,000\end{array}$$ Variable costs change with respect to the number of doughnuts sold. Compute the budgeted operating income for each of the following deviations from the original budget data. (Consider each case independently.) 1\. \(A\) 10 \(\%\) increase in contribution margin, holding revenues constant 2\. \(A\) 10 \(\%\) decrease in contribution margin, holding revenues constant 3\. \(A 5 \%\) increase in fixed costs 4\. A \(5 \%\) decrease in fixed costs 5\. An \(8 \%\) increase in units sold 6\. \(\mathrm{An} 8 \%\) decrease in units sold 7\. \(A \cdot 10 \%\) increase in fixed costs and a \(10 \%\) increase in units sold 8\. \(A 5 \%\) increase in fixed costs and a \(5 \%\) decrease in variable costs.
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