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Quiz 01] what is marginal analysis?

Marginal analysis, quite simply, balances the additional benefits from an action against the

additional cost. In any case, be it a firm deciding whether or not to expand production, a

student deciding if another beer is a good idea, or a professor choosing to give an extra exam,

optimal performance requires that benefits and costs be equilibrated on the margin. What this

means is that if the additional benefit exceeds the additional cost, take the action. Keep taking

it as long as the benefit exceeds the cost, and to ensure that all excess benefits (those that

exceed costs) are accrued, do it until for the last action, the benefits just equal the costs.

Marginal Costs

Marginal Costs are the additional costs imposed when one more unit is produced. If the cost

of making 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, the marginal cost of producing the tenth piece of pizza is $20. The table below illustrates the relationship between production, total costs,and marginal costs. Notice that total costs always rise as

production increases even though marginal costs may not rise.

Marginal costs tend to rise as production

increases. One explanation for this is that when a firm grows

very large, it becomes more and more difficult to manage the organization and costs

rise. Another possibility is that producing more and more of a particular product becomes more difficult due to technology or resource limitations. When trying to clean up the air, for

example, the first efforts are relatively inexpensive. A law can mandate, for example, that the dirtiest cars be taken off the

road. But as one tries to make the air cleaner and cleaner, more expensive technology is needed. Therefore, marginal costs rise. The rise in Marginal Costs is shown in the chart above.

Marginal Benefits

Marginal Benefits are the additional benefits received when one more unit is produced. Benefits can be expressed in terms of units of utility or satisfaction, or sometimes they can be

expressed in dollar amounts. The table below charts the marginal and total benefits from consuming pieces of pizza. The utility units are expressed in dollar terms.

Quantity Total

Cost

Marginal

Cost

0 0 --

1 5 5

2 10 5

3 17 7

4 25 8

5 34 9

6 44 10

7 58 14

8 73 15

9 90 17

10 110 20

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Good or service increases. Notice that

the marginal benefit from the second piece of

pizza is 25 units, but the marginal benefit of the tenth piece is only 2

units. This is because the first few pieces of

pizza are very appetizing when one is

hungry. But with each additional piece, the added benefits to

the person diminish.

Generally speaking, the marginal benefits curve slopes downward because we tend to like variety and too much of the

same thing gets very old. For instance, when we are used to breathing filthy air and that air has been cleaned for the first

time, the health benefits are large. But when one breathes relatively clean air already and that

air is made even cleaner, the health benefits are not as dramatic. The chart of total and marginal benefits above demonstrates this concept.

Economic Efficiency

Economic efficiency in our pizza example occurs where the MB and MC curves intersect. This occurs at a quantity of six pieces of pizza.

In general, the efficient level of output is where the Marginal Benefits just equal the Marginal Costs (point Q*). This is also the level at which the principle of

utilitarianism holds. Why is this case?

If production is less than Q*, for example at QL, then society could benefit overall by producing more. This is because the gains to society (measured by marginal benefits) exceed

the costs to society (measured by marginal costs). There will be a net gain to society of the difference between the marginal benefits and the marginal costs.

If production is greater than Q* at QH, then society

could benefit by producing less. This is because when we reduce output, the costs imposed on society fall by

more than the fall in marginal benefits. Therefore, the greatest good for the greatest number occurs at the intersection of marginal costs and marginal benefits.

Sometimes, the marginal benefits and costs are not "continuous"and we must make decisions about entire

projects based upon cost/benefit analysis. Suppose the courts must decide whether or not to

allow hundreds of acres of old-growth redwoods to be logged. One could do a cost/benefit

Quantity Total Benefits

Marginal Benefits

0 0 --

1 30 30

2 55 25

3 75 20

4 90 15

5 103 13

6 113 10

7 121 8

8 126 5

9 130 4

10 132 2

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analysis to determine what the benefits are to society for harvesting the timber versus the benefits for not harvesting the timber and preserving the forest and the ecosystems. The

efficient outcome would be to cut the trees until marginal benefits equal marginal costs. This result may not be possible, however, if an all or nothing decision must be made. The recent

compromise in the Headwaters Forest in which most old growth was preserved but other lands and cash were traded in return, certainly did not please either side completely, but perhaps the result was more efficient (but not necessarily more fair) than a solution that

allowed the entire area to be harvested, or a decision to ban production completely. The example over logging demonstrates that the costs and benefits arenot always easily

transferable into dollars. This makes the decisions very difficult and inherently more subjective.

MARGINAL COST

In economics and finance, marginal cost is the change in total cost that arises when the

quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. Mathematically, the marginal cost (MC) function is expressed as the first derivative of

the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next

unit produced. A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any

additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost

of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the

longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information asymmetries, the presence of negative or positive externalities, transaction costs, price

discrimination and others.

Cost functions and relationship to average cost-In the simplest case, the total cost

function and its derivative are expressed as follows, where Q represents the production

quantity, VC represents variable costs, FC represents fixed costs and TC represents total

costs.

Since (by definition) fixed costs do not vary with production quantity, it drops out of the

equation when it is differentiated. The important conclusion is that marginal cost is not

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related to fixed costs. This can be compared with average total cost or ATC, which is the total cost divided by the number of

units produced and does include fixed costs.

For discrete calculation without calculus, marginal cost equals the change in total (or variable) cost that comes with each additional unit produced. For instance, suppose the total

cost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. The marginal cost of producing the second shoe is $40 - $30 = $10.

Marginal cost is not the cost of producing the "next" or "last" unit. As Silberberg and Suen

note the cost of the last unit is the same as the cost of the first unit and every other unit. In the short run increasing production requires using more of the variable input - conventionally assumed to be labor. Adding more labor to a fixed capital stock reduces the marginal product

of labor because of the diminishing marginal returns. This reduction in productivity is not limited to the additional labor needed to produce the marginal unit - the productivity of every

unit of labor is reduced. Thus the costs of producing the marginal unit of output has two components: the cost associated with producing the marginal unit and the increase in average costs for all units produced due to the “damage” to the entire productive process (∂AC/∂q)q.

The first component is the per unit or average cost. The second unit is the small increase in costs due to the law of diminishing marginal returns which increaes the costs of all units of

sold.[1] Therefore, the precise formula is:

MC = AC + (∂AC/∂q) q.

Marginal costs can also be expressed as the cost per unit of labor divided by the marginal product of labor.

MC = ∆VC∕∆q;

∆VC = w∆L;

MC = w∆L;/∆q;

∆L∕∆q the change in quantity of labor to affect a one unit change in output = 1∕MPL.

Therefore MC = w∕MPL SInce the wage rate is assumed constant marginal cost and marginal

product of labor have an inverse relationship - if marginal cost is increasing (decreasing) the

marginal product of labor is decreasing (increasing).

Marginal Costs not affected by changes in fixed cost

Marginal Costs are not affected by changes in fixed cost. Marginal costs can be expressed as ∆C(q)∕∆Q. Since fixed costs do not vary with (depend on) changes in quantity, MC is ∆VC∕∆Q. Thus if fixed cost were to double MC would not be affected and consequently the

profit maximizing quantity and price would not change. this can be ilustrated by graphing the short run total cost curve and the short run variable cost curve. The shape of the curves are

identical. Each curve initially increases at a decreasing rate reaches and inflection point then increases at a decreasing rate. the only difference between the curves is that the SRVC curve

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begins from the origin while the SRTC curve originates on the y-axis. The distance of the origin of the SRTC above the origin represents the fixed cost - the vertical distance between

the curves. This distant remains constant as the quantity produced Q increases. MC is the slope of the SRVC curve. A change in fixed cost would be reflected by a change in the

vertical distance between the SRTC and SRVC curve. Any such change would have no effect on the shape of the SRVC curve and therefore its slope at any point - MC.

Externalities

Externalities are costs (or benefits) that are not borne by the parties to the economic transaction. A producer

may, for example, pollute the environment, and others may bear those costs. A consumer may consume a good

which produces benefits for society, such as education; because the individual does not receive all of the benefits, he may consume less than efficiency would

suggest. Alternatively, an individual may be a smoker or alcoholic and impose costs on others. In these cases, production or consumption of the good in question may differ from the

optimum level.

Negative Externalities of Production

Much of the time, private and social costs do not

diverge from one another, but at times social costs may be either greater or less than private costs. When

marginal social costs of production are greater than that of the private cost function, we see

the occurrence of a negative externality of production. Productive processes that result in pollution are a textbook example of production that creates negative externalities.

Such externalities are a result of firms externalising their costs onto a third party in order to

reduce their own total cost. As a result of externalising such costs we see that members of society will be negatively affected by such behavior of the firm. In this case, we see that an increased cost of production on society creates a social cost curve that depicts a greater cost

than the private cost curve.In an equilibrium state we see that markets creating negative externalities of production will overproduce that good. As a result, the socially optimal

production level would be lower than that observed.

Cost Functions

Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

FC = 420

VC = 60Q + Q2

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TC = 420 + 60Q + Q2

Marginal Costs (MC) = dTC/dQ

MC = 60 +2Q

Average Total Cost (ATC) = Total Cost/Q

ATC = (420 + 60Q + Q2)/Q

ATC = 420/Q + 60 + Q

Average Fixed Cost (AFC) = FC/Q

AFC = 420/Q

Average Variable Costs = VC/Q

AVC = (60Q + Q2)/Q

AVC = 60 + Q

MARGINAL REVENUE

A curve that graphically represents the relation between the marginal revenue received by a

firm for selling its output and the quantity of output sold. A firm maximizes profit by

producing the quantity of output found at the intersection of the marginal revenue curve and

marginal cost curve. The marginal revenue curve for a firm with no market control is

horizontal. The marginal revenue curve for a firm with market control is negatively sloped

and lies below the average revenue curve. A marginal revenue curve is the graphical relation

between the marginal revenue a firm receives from production and the quantity of output

produced. The marginal revenue curve reflects the degree of market control held by a firm.

For a perfectly competitive firm with no market control, the marginal revenue curve is a

horizontal line. Because a perfectly competitive firm is a price taker and faces a horizontal

demand curve, its marginal revenue curve is also horizontal and coincides with its average

revenue (and demand) curve.

For firms with more market control, especially monopoly, the average revenue curve is negatively-sloped. Because a firm with market control is a price maker and faces a

negatively-sloped demand curve, its marginal revenue curve is also negatively sloped and lies below its average revenue (and demand) curve.

Perfect Competition-Perfect competition is a market structure with a large number of small

firms, each selling identical goods. Perfectly competitive firms have perfect knowledge and perfect mobility into and out of the market. These conditions mean perfectly competitive firms are price takers, they have no market control and receive the going market price for all

output sold.

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Marginal revenue is

commonly represented by

a marginal revenue curve, such as the one labeled MR and displayed in the exhibit to the right. This particular marginal revenue curve is that for zucchini sales by Phil the zucchini

grower, a presumed perfectly competitive firm.

The vertical axis measures marginal revenue and the horizontal axis measures the quantity of output (pounds of zucchinis). Although quantity on this particular graph stops at 10 pounds of

zucchinis, the nature of perfect competition indicates it could easily go higher.

This curve indicates that if Phil sells the first pound of zucchinis (an increase in production from 0 to 1), then his extra revenue is $4. However, if he sells his tenth pound (an increase in

production from 9 to 10), then he also receives $4 of extra revenue. Should he sell his hundredth pound (an increase in production from 99 to 100), then he moves well beyond the graph, but his marginal revenue remains at $4.Because Phil is a perfectly competitive firm,

his marginal revenue curve is also his demand curve and his average revenue curve. All three curves coincide for perfect competition.

MARGINAL PRODUCT : A curve that graphically illustrates the relation between marginal

product and the quantity of the variable input, holding all other inputs fixed. This curve indicates the incremental change in output at each level of a variable input. The marginal product curve is one of three related curves used in the analysis of the short-run production of

a firm. The other two are total product curve and average product curve. The marginal product curve plays in key role in the economic analysis of short-run production by a firm.

The marginal product curve illustrates how marginal product is related to a variable input. While the

standard analysis of short-run production relates marginal product to labor, a marginal product

curve can be constructed for any variable input.

The diagram to the right graphically represents the

relation between marginal product and the variable input. This particular curve is derived from the

hourly production of Super Deluxe TexMex Gargantuan Tacos (with sour cream and jalapeno peppers) as Waldo's TexMex Taco World

restaurant employs additional workers. The number of workers, measured on the horizontal axis, ranges

from 0 to 10 and the marginal Gargantuan Taco production of each extra worker, measured on the vertical axis, ranges from 0 to 30.

The shape of this marginal product curve is worth

noting. For the first two workers of variable input, marginal product increases, as each added worker contributes more to the total production of Gargantuan Tacos than previous workers.

This increasing marginal product is reflected in a positive slope of the marginal product curve.Beyond the third worker, the marginal product declines, as each added worker contributes less to the total production of Gargantuan Tacos than the previous worker. This

Marginal Revenue Curve,

Zucchini Style

Marginal Product Curve

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decreasing marginal product is seen as a negative slope. The marginal product eventually declines until it reaches zero and even becomes negative. This results as the marginal product

curve cuts through the horizontal axis.The hump-shape of the marginal product curve embodies the essence of the analysis of short-run production. The upward-sloping portion of

the marginal product curve, up to the third worker, is due to increasing marginal returns. Decreasing marginal returns sets in after the marginal product curve peaks with the second worker and declines for the third worker. In particular, this declining segment of the marginal

product curve reflects the law of diminishing marginal returns.

Quiz 02 and 03 APPLYING MARGINAL ANALYSIS

Instead of applying a top down perspective on hotel departments and analyzing aggregate

figures, marginal analysis is about identifying the economic entities within the business and comparing the value to the costs they generate. Obviously the former should be greater than

the latter. Marginalism is anything but rocket science. Rather, it is a mindset and requires the willingness to examine every area of a business without taboos. How much incremental value

does an entity generate for the business? By how much would costs decrease if it was discontinued? By how much would value increase if it was augmented? Often the analysis comes down to comparing incremental revenues to the costs generated by the economic

entity. This is however not always the case, as the concept of value encompasses more than revenues and includes such benefits as the enhancement of guest experience, increased team-

member motivation or improvement of the business‟ reputation. The fundamental principle underlying marginal analysis is the explicit comparison of the incremental value versus incremental cost generated by an economic entity. Let‟s look at some examples of entities

where marginalism can be useful. This list is far from exhaustive.

Operating days and hours of profit and service centers-The trading times of outlets should be reviewed on a regular basis. What is the cost/benefit ratio of each operating hour?

The business hours of restaurants, bars, fitness clubs, etc … are often based on habits and rarely questioned. In many hotels, outlet operating hours are the same for every day of the week, despite potential regular variations in business patterns and guest demand among them.

Is the value generated by each hour of operation, especially at the beginning and the end of a day, invariably higher than the costs? If the revenues generated do not cover the costs

incurred, is there another reason for maintaining the hours of operation? Such reasons may be expectations by the hotel‟s guests. In any case, the value generated must outweigh the costs and it must be stated explicitly. This analysis can also be extended to operating days. Hotels

with several food and beverage outlets often operate all of them seven days a week, although some days may notoriously generate low revenues. Closing a bar or restaurant for a day per

week may boost outlet profitability, as all staff members take their off days simultaneously. This substantially reduces required staffing to operate the outlet. Annual closings may also have a positive impact on profit. Closing an outlet for a few weeks per year during a slow

season allows the scheduling of all annual staff vacations at the same time. This reduces the team size required to run the outlet. Such decisions are not solely based on financials. Guest

expectations, quality criteria, etc … play an important role in finding the right solution. Nonetheless it is critical, that the costs and value linked to such decisions are clearly spelled out. The converse may also apply. An outlet may be opening too late or closing too early and

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thus miss valuable revenue opportunities. Extending operating hours may be beneficial and marginal analysis helps in making the right decision.

Shifts and working hours-A similar challenge is posed by rota planning. Is the number of

shifts and the work-time schedule truly based on business requirements or once again driven by habits? A daily productivity measurement tool with some clear productivity standards by

outlet and department will help monitor an operation‟s ability to correlate the scheduling of resources with operational needs. Often, human resources and money are wasted because of ineffective scheduling on slow days (i.e. week-ends) and slow periods (i.e. between meals or

early/late hours). This analysis is closely related to the previous one addressing operating hours, as a change in shift planning may convert an unprofitable operating hour into a

profitable one. The exercise is easier for shifts in revenue generating positions such as restaurant staff, as the cost of a shift or of working hours can be directly put against the incremental revenue generated within the time period being analysed. However even for non-

revenue positions the cost of a scheduled time unit should be set against the value it generates.

Profit centers-Do profit centers truly deserve their name or do they simply generate revenue

without profit margin? A food and beverage department yielding a low profit as per Uniform System of Accounts for the Lodging Industry will often effectively make losses when all

relevant costs are attributed to it. Whilst the USALI allocates direct costs to their respective departments, marginal analysis goes further and considers all costs directly generated by a profit center, including opportunity cost. The fact that such analysis is complicated does not

diminish the importance of the exercise. Energy, credit card commissions, G&A resources, etc … are considered undistributed operating expenses under USALI. They need however to be included in marginal analysis in order to calculate the true profitability of a profit center.

While the cost of energy has often been neglected in the past, the increases of recent years have made energy a critical cost factor. Opportunity cost refers to the foregone benefits of an

alternative operation. For example: Is the marginal value generated by an F&B outlet higher than if the space was leased out or converted into meeting space? This question may be relevant in hotels with several food and beverage outlets. Outside catering is also an area

worthy of detailed analysis. Hotels not specialized in this business often overestimate the profitability of out-of-house catering. The P&Ls of events (when they are done at all)

frequently do not consider such items as the time spent on booking, planning and preparing the event. They also overlook such costs as time spent on invoice preparation, account collection, energy, credit card commission, increased loss and breakage of equipment, etc ….

Business processes-Marketing campaigns, training activities, F&B promotions etc … fall under the category of business processes. Such economic entities are more difficult to analyze in the context of marginalism as: 1) The value generated is often less tangible and difficult to

state in monetary terms; and 2) The value often comes with a time lag and sometimes over several years, whereas the costs are incurred within a year. Despite these difficulties,

marginal analysis should still be applied. One major advantage of the exercise is that objectives, costs and expected value creation have to be explicitly stated. In reality, a positive net effect of such processes is often taken for granted without explicit attempt to define it.

While an F&B promotion can easily be analysed in terms of incremental costs versus revenues generated, this is more complicated for image campaigns or training programmes.

But here also the value created has to be higher than the costs incurred, and it must be stated with a clear time frame.

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Other uses of marginal analysis-Marginal analysis can also be applied to customer segments or single accounts. Does a hotel maintain any transactions and contracts that are

unprofitable after accounting for all direct costs? Such costs pertain to distribution (GDS fees, travel agent commissions, …), the variable cost of stay, revenue collection, opportunity cost

(displacement of alternative business), etc … The costs of distribution or channel costs can shave off a good portion of the room rate and are often underestimated. An account with a high room rate and high distribution costs may be less profitable than an account with a lower

rate and distribution cost. At the same time, third party channels frequently generate incremental profitable business otherwise unavailable to a hotel, despite potentially high

distribution costs. On the other hand, is the hotel rejecting business which might be detrimental to departmental profit percentages but would yield a positive profit margin? A strong orientation towards departmental profit percentages increases this risk. From a purely

financial perspective and in the short-run, rooms must be sold at rates covering at least their variable costs in order to generate a profit. Taking in groups at deeply discounted rates may

make financial sense in low demand periods, when servicing can be ensured through the base staffing of a hotel. Once extra staff has to be scheduled (breakfast cooks & waiters, porters, check-in staff) the low margins are often eroded by an increase in variable cost.

Reward Systems-Reward systems must be aligned with the ultimate objectives of the

company. This is important in the context of marginalism. Are Sales Managers for example rewarded based on REVPAR or market share development, rather than GOPPAR? In such

cases, they will likely pay less attention to the profitability of business and rather focus on room revenue maximization. Executive Chefs‟ bonuses are sometimes based on food cost percentages instead of total F&B profit in Dollar terms. This encourages them to focus on

low food cost percentage rather than high dollar margin items. In addition, Chefs who have menu pricing discretion may set prices at excessively high levels, harming the volume-

margin mix. This may be beneficial to the food cost percentage but negatively impact total F&B profit in monetary terms.

Conclusion-Marginal analysis is a powerful tool to optimize the value creation ability of a business. It is detail oriented and does not replace high level strategic planning. What‟s more,

the decisions made and the actions taken in marginal analysis must be compatible with the overall, long-term strategy of the company. But within the context of a specific businesses

strategy, marginal analysis is useful to ensure that the operation is run as effectively as possible. The costs and value generated by economic entities must be explicitly defined. In reality this happens too rarely. When the value created is of non-monetary nature, the analysis

is more complicated but remains nonetheless critical. High-level average and aggregate figures are useful for reporting and benchmarking purposes. For fine-tuning and action

planning however, marginal analysis is more powerful. It can be applied to all economic entities within a business.

Operating Gearing and Marginal Analysis

If you have an activity, and it has high fixed costs compared to it‟s variable costs, then that

activity has high operating gearing.When operating gearing (OG) is high, a small change in sales will have a much bigger effect on profit, so you can say that profits are more sensitive

to activity volume when OG is high.

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Marginal analysis-If you need to make a decision that involves a limited time, and small changes to existing

practice, you mostly care about the variable costs. (Variable costs are the same thing as marginal costs).

Variable costs change depending on the outcome of the decision, making them a relevant cost.

In the same vein, fixed costs are irrelevant because the decision won‟t affect them. Marginal analysis is what

you use to make short term decisions.

So what are some decisions marginal analysis might be used on? It‟s normally used in these four „key decision areas‟:

Acception / rejection of special contracts

Determining the most efficient way to use limited resources

Decisions on making or buying something (aka outsourcing decisions)

Closing or continuation decisions

We‟ll go through each of the decision types in turn, with examples to explain.

Accepting / rejection of special contracts -If you remember the company that made llamas from the last post,

they have a spare capacity to make more llamas. A company overseas has offered to buy 300 llamas at £13 each

(normal selling price is £14). As before, the fixed costs are £500 and the variable cost per unit is £12. Should

they accept the offer?

There isn‟t really a right answer to this. By my calculations, they‟ll make 300 × £13 = £3,900 in revenue, and

the cost will be 300 × £12 = £3600. You don‟t need to include fixed costs, as they‟re being paid out regardless

of whether this decision is made.There are more factors than money to consider here though. Should they be

selling off the capacity for that price, or for more? What if other customers who have paid the higher price

complain? But the buyer is from overseas, maybe this purchase will he lp them enter a new market.So there isn‟t a definite right answer here!

Determining the most efficient way to use limited resources -There‟s a company that makes 3 different

products: Chalk, cheese and benzoylmethylecgonine. Here‟s some more info about the products:

Machine time is limited to 148 hours / week. So what combination of products should be manufactured for the

highest profit?

So in this case, the machine time is the limited resource. The first thing to do is calculate how much profit each product makes per unit. This is just revenue – variable costs, so gives us:

Chalk: £15

Cheese: £12

Benzoylmethylecgonine: £11

Now divide the profit by the machine time to work out how much profit each product makes in an hour of machine time:

Chalk: £3.75

Cheese: £4

Benzoylmethylecgonine: £2.75

So now we have everything we need to solve the problem. Obviously we want to make as many units of cheese

as possible as it brings in the most profit, so let‟s have the machine make 20 units of cheese (to fill the weekly

demand, any more will be a waste of resources). As it has a machine time of 3 hours, making 20 units of cheese

will take up 60 of the machines 148 hours, leaving 88 hours.The next most profitable product is chalk, so we

want to make as much of that as we can. To fulfil the demand of 25 units would take 100 machine hours though,

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so we can‟t completely fulfil the demand. Therefore we should just use all of the remaining 88 hours to make 22 units of chalk.

So the answer is:20 units of cheese and 22 units of chalk is the most profitable way of using the machine.

Decisions on making or buying something (outsourcing decisions)-Another example. A company needs to

acquire a chip for one of its products. They can subcontract the production of it, costing £35 p er chip, or produce

it themselves for total variable costs of £28 per unit.The problem is, the company doesn‟t have any spare

capacity, so they‟ll have to reduce the output of something else (call it product B) in order to make the new one.

Product B makes a contribution of £15.

What decision do they take?

Answer:What are the relevant costs here? It will cost £28 per unit, plus the £15 they „lose‟ from being unable to

make Product B. That gives a total of £43. Therefore they should subcontract it, as the co st to them is less.There

are a couple of other factors to consider though. Outsourcing means the company loses control over the quality of it, and there could be problems with the supply down the line.

References

Internet

HNDM notes

K.N. Thushara samarasinghe

HNDM -15