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Managerial economics


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Managerial economics

  1. 1. MANAGERIAL ECONOMICS Quiz 01] what is marginal analysis? Marginal analysis, quite simply, balances the additional benefits from an action against theadditional cost. In any case, be it a firm deciding whether or not to expand production, astudent 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 thismeans is that if the additional benefit exceeds the additional cost, take the action. Keep takingit as long as the benefit exceeds the cost, and to ensure that all excess benefits (those thatexceed costs) are accrued, do it until for the last action, the benefits just equal the costs.Marginal CostsMarginal Costs are the additional costs imposed when one more unit is produced. If the costof making 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, the marginalcost of producing the tenth piece of pizza is $20. The table below illustrates the relationshipbetween production, total costs,and marginal costs. Notice that total costs always rise asproduction increases even though marginal costs may not rise. Total MarginalQuantity Cost Cost 0 0 -- 1 5 5 2 10 5 Marginal costs tend to 3 17 7 rise as production increases. One 4 25 8 explanation for this is 5 34 9 that when a firm grows 6 44 10 very large, it becomes more and more difficult to manage the organization and costs 7 58 14 rise. Another possibility is that producing more and more of a 8 73 15 particular product becomes more difficult due to technology or 9 90 17 resource limitations. When trying to clean up the air, for 10 110 20 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, moreexpensive technology is needed. Therefore, marginal costs rise. The rise in Marginal Costs isshown in the chart above.Marginal BenefitsMarginal 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 beexpressed in dollar amounts. The table below charts the marginal and total benefits fromconsuming pieces of pizza. The utility units are expressed in dollar terms.1|P a g e
  2. 2. MANAGERIAL ECONOMICS Good or service Total Marginal increases. Notice thatQuantity Benefits Benefits the marginal benefit0 0 -- from the second piece of1 30 30 pizza is 25 units, but the marginal benefit of the2 55 25 tenth piece is only 23 75 20 units. This is because4 90 15 the first few pieces of pizza are very5 103 13 appetizing when one is6 113 10 hungry. But with each additional piece, the added benefits to7 121 8 the person diminish.8 126 5 Generally speaking, the marginal benefits curve slopes9 130 4 downward because we tend to like variety and too much of the10 132 2 same thing gets very old. For instance, when we are used to breathing filthy air and that air has been cleaned for the firsttime, the health benefits are large. But when one breathes relatively clean air already and thatair is made even cleaner, the health benefits are not as dramatic. The chart of total andmarginal 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 Q L, then society could benefit overall byproducing more. This is because the gains to society (measured by marginal benefits) exceedthe 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 Q H, 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 entireprojects based upon cost/benefit analysis. Suppose the courts must decide whether or not toallow hundreds of acres of old-growth redwoods to be logged. One could do a cost/benefit2|P a g e
  3. 3. MANAGERIAL ECONOMICSanalysis to determine what the benefits are to society for harvesting the timber versus thebenefits for not harvesting the timber and preserving the forest and the ecosystems. Theefficient outcome would be to cut the trees until marginal benefits equal marginal costs. Thisresult may not be possible, however, if an all or nothing decision must be made. The recentcompromise in the Headwaters Forest in which most old growth was preserved but otherlands and cash were traded in return, certainly did not please either side completely, butperhaps the result was more efficient (but not necessarily more fair) than a solution thatallowed the entire area to be harvested, or a decision to ban production completely. Theexample over logging demonstrates that the costs and benefits arenot always easilytransferable into dollars. This makes the decisions very difficult and inherently moresubjective. MARGINAL COSTIn economics and finance, marginal cost is the change in total cost that arises when thequantity produced changes by one unit. That is, it is the cost of producing one more unit of agood. Mathematically, the marginal cost (MC) function is expressed as the first derivative ofthe 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 newfactory. In practice, the analysis is segregated into short and long-run cases, and over thelongest run, all costs are marginal. At each level of production and time period beingconsidered, marginal costs include all costs which vary with the level of production, andother costs are considered fixed costs.A number of other factors can affect marginal cost and its applicability to real worldproblems. Some of these may be considered market failures. These may include informationasymmetries, the presence of negative or positive externalities, transaction costs, pricediscrimination and others. Cost functions and relationship to average cost-In the simplest case, the total costfunction and its derivative are expressed as follows, where Q represents the productionquantity, VC represents variable costs, FC represents fixed costs and TC represents totalcosts.Since (by definition) fixed costs do not vary with production quantity, it drops out of theequation when it is differentiated. The important conclusion is that marginal cost is not3|P a g e
  4. 4. MANAGERIAL ECONOMICS 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 (orvariable) cost that comes with each additional unit produced. For instance, suppose the totalcost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. The marginal cost ofproducing the second shoe is $40 - $30 = $10.Marginal cost is not the cost of producing the "next" or "last" unit. As Silberberg and Suennote the cost of the last unit is the same as the cost of the first unit and every other unit. In theshort run increasing production requires using more of the variable input - conventionallyassumed to be labor. Adding more labor to a fixed capital stock reduces the marginal productof labor because of the diminishing marginal returns. This reduction in productivity is notlimited to the additional labor needed to produce the marginal unit - the productivity of everyunit of labor is reduced. Thus the costs of producing the marginal unit of output has twocomponents: the cost associated with producing the marginal unit and the increase in averagecosts 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 incosts due to the law of diminishing marginal returns which increaes the costs of all units ofsold.[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 marginalproduct 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 costMarginal 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 theprofit maximizing quantity and price would not change. this can be ilustrated by graphing theshort run total cost curve and the short run variable cost curve. The shape of the curves areidentical. Each curve initially increases at a decreasing rate reaches and inflection point thenincreases at a decreasing rate. the only difference between the curves is that the SRVC curve4|P a g e
  5. 5. MANAGERIAL ECONOMICSbegins from the origin while the SRTC curve originates on the y-axis. The distance of theorigin of the SRTC above the origin represents the fixed cost - the vertical distance betweenthe curves. This distant remains constant as the quantity produced Q increases. MC is theslope of the SRVC curve. A change in fixed cost would be reflected by a change in thevertical distance between the SRTC and SRVC curve. Any such change would have no effecton 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 wouldsuggest. Alternatively, an individual may be a smoker or alcoholic and impose costs onothers. In these cases, production or consumption of the good in question may differ from theoptimum 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. Whenmarginal social costs of production are greater than that of the private cost function, we seethe occurrence of a negative externality of production. Productive processes that result inpollution 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 toreduce their own total cost. As a result of externalising such costs we see that members ofsociety will be negatively affected by such behavior of the firm. In this case, we see that anincreased cost of production on society creates a social cost curve that depicts a greater costthan the private cost curve.In an equilibrium state we see that markets creating negativeexternalities of production will overproduce that good. As a result, the socially optimalproduction level would be lower than that observed. Cost FunctionsTotal Cost (TC) = Fixed Costs (FC) + Variable Costs (VC) FC = 420 VC = 60Q + Q 25|P a g e
  6. 6. MANAGERIAL ECONOMICS TC = 420 + 60Q + Q 2 Marginal Costs (MC) = dTC/dQ MC = 60 +2Q Average Total Cost (ATC) = Total Cost/Q ATC = (420 + 60Q + Q 2 )/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 REVENUEA curve that graphically represents the relation between the marginal revenue received by afirm for selling its output and the quantity of output sold. A firm maximizes profit byproducing the quantity of output found at the intersection of the marginal revenue curve andmarginal cost curve. The marginal revenue curve for a firm with no market control ishorizontal. The marginal revenue curve for a firm with market control is negatively slopedand lies below the average revenue curve. A marginal revenue curve is the graphical relationbetween the marginal revenue a firm receives from production and the quantity of outputproduced. 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 ahorizontal line. Because a perfectly competitive firm is a price taker and faces a horizontaldemand curve, its marginal revenue curve is also horizontal and coincides with its averagerevenue (and demand) curve.For firms with more market control, especially monopoly, the average revenue curve isnegatively-sloped. Because a firm with market control is a price maker and faces anegatively-sloped demand curve, its marginal revenue curve is also negatively sloped and liesbelow its average revenue (and demand) curve.Perfect Competition-Perfect competition is a market structure with a large number of smallfirms, each selling identical goods. Perfectly competitive firms have perfect knowledge andperfect mobility into and out of the market. These conditions mean perfectly competitivefirms are price takers, they have no market control and receive the going market price for alloutput sold.6|P a g e
  7. 7. MANAGERIAL ECONOMICS Marginal Revenue Curve, Zucchini Style 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 ofoutput (pounds of zucchinis). Although quantity on this particular graph stops at 10 pounds ofzucchinis, 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 productionfrom 0 to 1), then his extra revenue is $4. However, if he sells his tenth pound (an increase inproduction from 9 to 10), then he also receives $4 of extra revenue. Should he sell hishundredth pound (an increase in production from 99 to 100), then he moves well beyond thegraph, 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 threecurves coincide for perfect competition.MARGINAL PRODUCT : A curve that graphically illustrates the relation between marginalproduct and the quantity of the variable input, holding all other inputs fixed. This curveindicates the incremental change in output at each level of a variable input. The marginalproduct curve is one of three related curves used in the analysis of the short-run production ofa firm. The other two are total product curve and average product curve. The marginalproduct 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 thestandard analysis of short-run production relates marginal product to labor, a marginal productcurve can be constructed for any variable input.The diagram to the right graphically represents therelation between marginal product and the variableinput. This particular curve is derived from thehourly production of Super Deluxe TexMexGargantuan Tacos (with sour cream and jalapenopeppers) as Waldos TexMex Taco Worldrestaurant employs additional workers. The numberof workers, measured on the horizontal axis, rangesfrom 0 to 10 and the marginal Gargantuan Tacoproduction of each extra worker, measured on thevertical axis, ranges from 0 to 30. Marginal Product CurveThe shape of this marginal product curve is worthnoting. For the first two workers of variable input, marginal product increases, as each addedworker 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 productcurve.Beyond the third worker, the marginal product declines, as each added workercontributes less to the total production of Gargantuan Tacos than the previous worker. This7|P a g e
  8. 8. MANAGERIAL ECONOMICSdecreasing marginal product is seen as a negative slope. The marginal product eventuallydeclines until it reaches zero and even becomes negative. This results as the marginal productcurve cuts through the horizontal axis.The hump-shape of the marginal product curveembodies the essence of the analysis of short-run production. The upward-sloping portion ofthe 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 secondworker and declines for the third worker. In particular, this declining segment of the marginalproduct curve reflects the law of diminishing marginal returns.Quiz 02 and 03 APPLYING MARGINAL ANALYSISInstead of applying a top down perspective on hotel departments and analyzing aggregatefigures, marginal analysis is about identifying the economic entities within the business andcomparing the value to the costs they generate. Obviously the former should be greater thanthe latter. Marginalism is anything but rocket science. Rather, it is a mindset and requires thewillingness to examine every area of a business without taboos. How much incremental valuedoes an entity generate for the business? By how much would costs decrease if it wasdiscontinued? By how much would value increase if it was augmented? Often the analysiscomes down to comparing incremental revenues to the costs generated by the economicentity. This is however not always the case, as the concept of value encompasses more thanrevenues and includes such benefits as the enhancement of guest experience, increased team-member motivation or improvement of the business‟ reputation. The fundamental principleunderlying marginal analysis is the explicit comparison of the incremental value versusincremental cost generated by an economic entity. Let‟s look at some examples of entitieswhere marginalism can be useful. This list is far from exhaustive. Operating days and hours of profit and service centers-The trading times of outletsshould 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 andrarely questioned. In many hotels, outlet operating hours are the same for every day of theweek, 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 aday, invariably higher than the costs? If the revenues generated do not cover the costsincurred, is there another reason for maintaining the hours of operation? Such reasons may beexpectations by the hotel‟s guests. In any case, the value generated must outweigh the costsand it must be stated explicitly. This analysis can also be extended to operating days. Hotelswith several food and beverage outlets often operate all of them seven days a week, althoughsome days may notoriously generate low revenues. Closing a bar or restaurant for a day perweek 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 alsohave a positive impact on profit. Closing an outlet for a few weeks per year during a slowseason allows the scheduling of all annual staff vacations at the same time. This reduces theteam size required to run the outlet. Such decisions are not solely based on financials. Guestexpectations, 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 spelledout. The converse may also apply. An outlet may be opening too late or closing too early and8|P a g e
  9. 9. MANAGERIAL ECONOMICSthus miss valuable revenue opportunities. Extending operating hours may be beneficial andmarginal analysis helps in making the right decision.Shifts and working hours-A similar challenge is posed by rota planning. Is the number ofshifts and the work-time schedule truly based on business requirements or once again drivenby habits? A daily productivity measurement tool with some clear productivity standards byoutlet and department will help monitor an operation‟s ability to correlate the scheduling ofresources with operational needs. Often, human resources and money are wasted because ofineffective scheduling on slow days (i.e. week-ends) and slow periods (i.e. between meals orearly/late hours). This analysis is closely related to the previous one addressing operatinghours, as a change in shift planning may convert an unprofitable operating hour into aprofitable one. The exercise is easier for shifts in revenue generating positions such asrestaurant staff, as the cost of a shift or of working hours can be directly put against theincremental 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 itgenerates.Profit centers-Do profit centers truly deserve their name or do they simply generate revenuewithout profit margin? A food and beverage department yielding a low profit as per UniformSystem of Accounts for the Lodging Industry will often effectively make losses when allrelevant costs are attributed to it. Whilst the USALI allocates direct costs to their respectivedepartments, marginal analysis goes further and considers all costs directly generated by aprofit center, including opportunity cost. The fact that such analysis is complicated does notdiminish the importance of the exercise. Energy, credit card commissions, G&A resources,etc … are considered undistributed operating expenses under USALI. They need however tobe 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 yearshave made energy a critical cost factor. Opportunity cost refers to the foregone benefits of analternative operation. For example: Is the marginal value generated by an F&B outlet higherthan if the space was leased out or converted into meeting space? This question may berelevant in hotels with several food and beverage outlets. Outside catering is also an areaworthy of detailed analysis. Hotels not specialized in this business often overestimate theprofitability 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 preparingthe event. They also overlook such costs as time spent on invoice preparation, accountcollection, energy, credit card commission, increased loss and breakage of equipment, etc ….Business processes-Marketing campaigns, training activities, F&B promotions etc … fallunder the category of business processes. Such economic entities are more difficult to analyzein the context of marginalism as: 1) The value generated is often less tangible and difficult tostate in monetary terms; and 2) The value often comes with a time lag and sometimes overseveral 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 thatobjectives, costs and expected value creation have to be explicitly stated. In reality, a positivenet 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 versusrevenues 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 statedwith a clear time frame.9|P a g e
  10. 10. MANAGERIAL ECONOMICS Other uses of marginal analysis-Marginal analysis can also be applied to customersegments or single accounts. Does a hotel maintain any transactions and contracts that areunprofitable 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 canshave off a good portion of the room rate and are often underestimated. An account with ahigh room rate and high distribution costs may be less profitable than an account with a lowerrate and distribution cost. At the same time, third party channels frequently generateincremental profitable business otherwise unavailable to a hotel, despite potentially highdistribution costs. On the other hand, is the hotel rejecting business which might bedetrimental to departmental profit percentages but would yield a positive profit margin? Astrong orientation towards departmental profit percentages increases this risk. From a purelyfinancial perspective and in the short-run, rooms must be sold at rates covering at least theirvariable costs in order to generate a profit. Taking in groups at deeply discounted rates maymake financial sense in low demand periods, when servicing can be ensured through the basestaffing 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 thecompany. This is important in the context of marginalism. Are Sales Managers for examplerewarded based on REVPAR or market share development, rather than GOPPAR? In suchcases, they will likely pay less attention to the profitability of business and rather focus onroom revenue maximization. Executive Chefs‟ bonuses are sometimes based on food costpercentages instead of total F&B profit in Dollar terms. This encourages them to focus onlow food cost percentage rather than high dollar margin items. In addition, Chefs who havemenu 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 totalF&B profit in monetary terms.Conclusion-Marginal analysis is a powerful tool to optimize the value creation ability of abusiness. 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 theoverall, long-term strategy of the company. But within the context of a specific businessesstrategy, marginal analysis is useful to ensure that the operation is run as effectively aspossible. The costs and value generated by economic entities must be explicitly defined. Inreality this happens too rarely. When the value created is of non-monetary nature, the analysisis more complicated but remains nonetheless critical. High-level average and aggregatefigures are useful for reporting and benchmarking purposes. For fine-tuning and actionplanning however, marginal analysis is more powerful. It can be applied to all economicentities within a business.Operating Gearing and Marginal AnalysisIf you have an activity, and it has high fixed costs compared to it‟s variable costs, then thatactivity has high operating gearing.When operating gearing (OG) is high, a small change insales will have a much bigger effect on profit, so you can say that profits are more sensitiveto activity volume when OG is high.10 | P a g e
  11. 11. MANAGERIAL ECONOMICSMarginal analysis-If you need to make a decision that involves a limited time, and small changes to existingpractice, you mostly care about the variable costs. (Variable costs are the same thin g 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 whatyou 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 decisionareas‟: 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 decisionsWe‟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. Shouldthey accept the offer?There isn‟t really a right answer to this. By my calculations, they‟ll make 300 × £13 = £3,900 in revenue, andthe cost will be 300 × £12 = £3600. You don‟t need to include fixed costs, as they‟re being paid out regardlessof whether this decision is made.There are more factors than money to consider here though. Should they beselling off the capacity for that price, or for more? What if other customers who have paid the higher pricecomplain? But the buyer is from overseas, maybe this purchase will help them enter a new market.So there isn‟ta definite right answer here!Determining the most efficient way to use limited resources -There‟s a company that makes 3 differentproducts: 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 thehighest profit?So in this case, the machine time is the limited resource. The first thing to do is calculate how much profit eachproduct makes per unit. This is just revenue – variable costs, so gives us: Chalk: £15 Cheese: £12 Benzoylmethylecgonine: £11Now divide the profit by the machine time to work out how much profit each product makes in an hour ofmachine time: Chalk: £3.75 Cheese: £4 Benzoylmethylecgonine: £2.75So now we have everything we need to solve the problem. Obviously we want to make as many units of cheeseas possible as it brings in the most profit, so let‟s have the machine make 20 units of cheese (to fill the weeklydemand, any more will be a waste of resources). As it has a machine time of 3 hours, making 20 units of cheesewill take up 60 of the machines 148 hours, leaving 88 hours.The next most profitable product is chalk, so wewant to make as much of that as we can. To fulfil the demand of 25 units would take 100 machine hours though,11 | P a g e
  12. 12. MANAGERIAL ECONOMICSso we can‟t completely fulfil the demand. Therefore we should just use all of the remaining 88 hours to make 22units 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 toacquire a chip for one of its products. They can subcontract the production of it, costing £35 p er chip, or produceit themselves for total variable costs of £28 per unit.The problem is, the company doesn‟t have any sparecapacity, 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 tomake Product B. That gives a total of £43. Therefore they should subcontract it, as the co st to them is less.Thereare a couple of other factors to consider though. Outsourcing means the company loses control over the qualityof it, and there could be problems with the supply down the line. References Internet HNDM notes K.N. Thushara samarasinghe HNDM -1512 | P a g e