Problem Understanding the nature of fixed and variable costs is extremely import

Question

Problem Understanding the nature of fixed and variable costs is extremely important to managers. This knowledge is used in planning, making strategic and tactical decisions, evaluating performandce and controlling operations Required: Form a team consisting of four persons. Each team member vwill be responsible for one of the following businesses: a. Retail store that sells music CDs b. Dental clinic c. Fast-food restaurant d. Auto repair shop 1. In each business decide what single measure best reflects the overall level of activity in the business and give examples of costs that are fixed and variable with respect to small changes in the measure of activity you have chosen Explain the relationship between the level of activity in each business and each of the following total fixed costs, fixed cost per unit of activity total variabie costs variable cost per unit of activity, total costs and average total cost per unit of activity 3. Discuss and refine your answers to each of the above questions with your group Which of the above businesses seems to have the highest ratic of variable to fxed costs? The lowest? Which of the businesses profits would be most sensiti e to changes in demand for its services? The east sensitve? Why?

Explanation / Answer

(1)

The single measure that can best reflect the overall activity is the number of CDs sold per period.

Fixed Cost Components

Variable Cost Components

(2)

When the level of activity changes for a small amount, the total fixed cost will remain unchanged. For example, when the sales of CD declines (or increases), there is no change in any of the components written under the fixed cost. So, the fixed cost per unit of activity will increase or reduce inversely with the respective reduction or increase of the activity.

The variable cost per unit goes with the unit activity and remain unchanged. For example, it does not matter how many CDs are sold, the per unit cost of purchase or the packaging cost or the inventory carrying cost per CD remains the same. As a result, the total variable cost will be exactly proportional to the number of CDs sold.

The total cost will be an addition of total fixed cost and total variable cost and will take the form of the straight line relationship which the unit variable cost is the slope and total fixed cost be the intercept. So, if 'v' be the unit variable cost, 'F' be the total fixed cost, and 'N' be the number of CDs sold, then the total cost as a function of N will be written as:

TC(N) = v.N + F

Average total cost per unit will hence be AC(N) = v + F/N. This is an equation will take the form of an asymptote which will denote an initial very sharp reduction of average cost with an increase of N and then a gradual damping of reduction.

(3)

An example estimate of these costs are shown which can be used for comparison

Fixed Cost components per month Estimate 1. Lease or rent paid for the store space $1,000 2. Fixed salary and wages paid to the employees 2100 3. Electricity expenses for the store $500 4. Equipment (e.g. music systems, computers etc.) maintenance cost $200 5. Advertisement and promotional expenses $450 6. Payment for telephone and internet connection $200 7. Cost of computer software installed for business $100 8. Cost of housekeeping, decoration, and cleansing $50 9. Fuel cost or third party charges for transportation. $200 Total fixed cost per month $4,800 Variable Cost Components per CD 1. The unit purchase cost of a CD (from the distributor) $12 2. Packaging cost while selling $0.50 3. Employee overtime expenses during peak seasons $0.12 4. Inventory carrying cost $0.05 5. Sales commission to employees $0.12 Total variable cost per unit $13

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