Accounting
Assessment of Costs and Profit
For a firm to survive it is essential that they manage their operations so that any production that takes place creates a profit. The assessment of whether goods are profitable for a firm and whether the firm should continue to produce them requires a careful examination of the costs.
In the case supplied where there are 50,000 workers, paid a wage of $80 a day, and other variable costs of $400,000 producing 200,000 units a day which are priced as $25 each, the position of the firm, with their profit or loss may be assessed at different fixed cost levels. In the first assessment the fixed costs are $1,000,000; in the second assessment the fixed costs are $3,000,000.
Assessment with fixed costs at $1,000,000
To assess the profit and efficiency of the firm, the first stage is to assess the total variable costs. Variable costs are those which change based on the level of production. The calculation for the total variable costs is shown in table 1
Table 1; Total variable costs
Number of workers (a)
50,000
Daily wage (b)
Total daily wage (c), (a x b)
4,000,000
Other variable costs (d)
400,000
Total variable costs (c + d)
4,400,000
With the total variable cost assessed it is possible to look at the average variable cost per unit, dividing the total variable cost by the number of units produced. This is shown in table 2.
Table 2 Average variable cost per unit
Total variable costs (a)
4,400,000
Number of units produced (b)
200,000
Average variable cost per unit (a/b)
22
From this the variable costs are 22, this means that the remaining 3 per unit that is received in revenue may be seen as the ‘contribution’, this is the revenue that will pay first for the fixed costs and when the fixed costs are covered will provide the profit (Seal et al., 2011).
The presence of a contribution means that the product has the potential to be profitable depending on the fixed costs. The next stage is to look at the average total cost. This adds in the fixed costs and is shown in table 3.
Table 3; Averse total cost
Total variable costs (a)
4,400,000
Total fixed costs (b)
1,000,000
Total costs (c) (a + b)
5,400,000
Number of units (d)
200,000
Average total cost (c/d)
27
The total average cost per unit is above the revenue per unit, so it is possible to see that the firm is making a loss on this product of 2 per unit. To assess the issue further the actual productivity of the workers may be assessed, this is shown in table 4.
Table 4; Worker productivity
Units per day (a)
200,000
Number of workers (b)
50,000
Units per worker per day (a/b)
4
The workers are producing a total of 4 units per person per day. If it is assumed that the number of units produced cannot be increased the firm is stuck with a loss. The loss is calculated in table 5.
Table 5; Loss when fixed costs are $1,000,000
Number of units sold (a)
200,000
Price per unit (b)
25
Total revenue (c ) (a x b)
5,000,000
Total costs
5,400,000
Profit/loss
-400,000
The firm is making a loss, and may need to consider whether or not production should be shut down. If the loss is sustained it may be argued that not only is there a loss being incurred, tying u the resources there is also an opportunity cost, as the resources may be used more probability for a different product (Gillespie, 2010). However there is also the potential that the product may help to create a profit. Even if the product itself is not profitable it may support the sale of complimentary items that makes a much higher profit margin. One example has been the printer market; firms will often subsidize the printers that are sold, with the aim of creating long-term profits by the ongoing sale of the printer cartridges (Thompson, 2007). The cellular telephone market also operates in a similar manner, with mobile phone service suppliers subsidizing the cost of the handsets in order to gain a contract from a customer, the cost of the subsidy is offset against the profit that will be gained on the service contract. Therefore, the firm will need to look at the impact that ending production may have on the sale of other goods. However unless there is a complimentary item then it would appear some changes may need to take place.
If there is a loss with the fixed costs of $1,000,000 it is will be expected that higher fixed costs will increase the loss.
Assessment with fixed costs at $3,000,000 per day
If the fixed costs are higher or increase the calculations will change and the average total cost per unit will change. The total and average variable costs will not change, so the same figures already calculated may be used. The average total cost is increased as shown in table 6.
Table 6; Average total cost with $3,000,000 fixed cost
Total variable costs (a)
4,400,000
Total fixed costs (b)
3,000,000
Total costs (c ) (a + b)
7,400,000
Number of units (d)
200,000
Average total cost (c/d)
37
The average total cost per unit is now 37; this is a significant increase and shows that the firm is loosing 12 per unit produced (37-25). This can be used to look at the new total loss incurred, which is shown in table 7.
Table 7; Loss for each scenario
Number of units sold (a)
200,000
Price per unit (b)
25
Total revenue (c ) (a x b)
5,000,000
Total costs
7,400,000
Profit/loss
-2,400,000
The loss has increased significantly. The decision whether or not to continue production remains the same as in the previous scenario, with the need to consider the overall impact it is having on the firm, either tying up resources and creating overall losses, or supporting the sale of complimentary items. If there are complimentary items, in this instance the profit would need to be higher to compensate for the losses compared with the previous scenario.
Reducing Employees
In both cases the way in which the firm may turn around the loss and break even is by adjusting the variable costs, assuming the fixed costs and total production cannot be changed. With the knowledge of the total loss for each scenario and the average wages, the potential for reducing the total cost by reducing the number of workers may be assessed. The calculation showing the number of workers that would need to be lost is shown in table 8.
Table 8; Reduction in workers required for breakeven
$1,000,000 fixed costs
$3,000,000 fixed costs
Loss
400,000
2,400,000
Average wage per employee
80
80
Number of employees
5,000
30,000
The scenario with fixed overheads of $1 million would require the workforce to be reduced by only 5,000, which is a 10% reduction, and would require the remaining employees to increase their productivity to 4.44 units per day, which also an increase may be seen as potentially viable as it is only 11% increase. However, in the scenario where the overheads are $3 million, the workforce would need to be reduced by 30,000, which is equivalent to a 60% reduction in the workforce. In order to continue producing the same level of units per day productivity would have to increase to 10 units per day, an increase the 150%, and unlikely to be viable. Therefore, while it may be argued that if fixed costs are $1 million the organization has the potential to make the changes necessary in order to breakeven, it is unlikely this is possible if the fixed costs of $3 million. In a scenario of $3 million fixed costs it is likely that a recommendation will be to cease production immediately. In this scenario of $1 million overheads there is the potential for improvements to be made to breakeven.
References
Gillespie a, (2010), Business Economics, Oxford, Oxford University Press
Seal, Will; Garrison, Ray H; Noreen Eric W, (2011), Management Accounting, McGraw-Hill Higher Education
Thompson JL, (2007), Strategic Management; Awareness and Change, London, Thompson Business Press.
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