Ma.

Cr
isol
B.Ol
i
cia August29,
2019

BSA-1A Si
r.Fr
it
z

Assi
gnment

LawofDi
mini
shi
ngRet
urns

Thel awofdi minishi

ngreturns,alsor eferr
edt oasthelawofdi mi
nishingmar ginalreturns,
st
at esthatinapr oducti
onpr ocess, asonei nputvari
ableisi
ncreased, therewi l
lbeapoi ntat
whicht hemar ginalperuni
tout putwi ll
starttodecrease,hol
dingallotherf actorsconst ant.I
n
otherwor ds,keepingallot
herf actorsconst ant,
theadditi
onaloutputgai nedbyanot heroneuni t
i
ncreaseoft hei nputvari
abl
ewi l
levent ual
lybesmal l
erthantheadditional outputgai nedbyt he
previousincreaseininputvariable.Atthatpoi nt
,thedimini
shi
ngmar ginalreturnstakeef fect.

Exampl
e

Consideracornf armerwi t
honeacreofland.Inadditi
ontoland,ot
herfactorsi
ncludequant
it
y
ofseeds,fert
il
izer,
wat er,
andlabor
.Assumet hef ar
merhasal r
eadydecidedhowmuchseed,
water,andlaborhewi l
l beusi
ngthisseason.Heisstil
ldeci
dingonhowmuchf erti
li
zert
ouse.
Ashei ncr
easest heamountoff ert
il
izer
,theoutputofcornwill
incr
ease.Itmayalsoreacha
poi
ntwher etheout putactual
l
ybeginstodecreasesincetoomuchf ert
il
izercanbecome
poi
sonous.

Thelawofdiminishingr
eturnsst
atesthattherewillbeapointwher
et headdit
ionaloutputof
corngai
nedfrom oneadditi
onalunitoffert
il
izerwil
lbesmallert
hantheaddit
ionaloutputof
cornfr
om thepreviousi
ncreasei
nf ert
il
izer
.Thistableshowstheoutputofcornperunitof
fer
ti
li
zer:

Out
putofcor
nperuni
tfer
ti
li
zer
Far
merOut
put

Asthefarmeri
ncr
easesfr
om onetotwounitsofferti
l
izer,tot
aloutputincr
easesf r
om 100to
250earsofcor
n.Ther
eforethemargi
nal
,oraddit
ional,earsofcorngainedf r
om onemor euni
t
offer
ti
li
zeri
s150(250-100).Fr
om twotothr
eeuni t
soff erti
l
izer
,thetotaloutputi
ncr
eases
fr
om 250to425earsofcorn,a175margi
nalincr
ease.

Atwhatpointdoesthelawofdiminishingret
urnssetin?Lookf orthepoi ntatwhichthe
mar gi
nali
ncr
easeisatthehighestpointandthenextmar ginalincreaseisless.I
nthi
sexample,
thatoccur
saftert
hef ar
meraddst hethir
dunitoffer
ti
lizer
.Att hreeunits,t
hemar gi
nalout
putin
earsofcorni
s175, butwhenthefourthuniti
sadded,themar ginaloutputdropsto125.

Again,thi
sdoesnotmeant het ot
al product
ionstar
tstodecrease.I
nfact,thetot
alproduct
ioni
s
sti
l
l i
ncreasi
ng,asshowni nt hetotalearsofcorncolumn.Alsonotethatatthesixt
hunitof
fer
til
izer,
thefarmerstar
tstoexper iencenegati
vereturns,wheret
heincreaseinfer
ti
li
zer
actuall
ydecreasesthetotaloutputandt hemarginaloutputbecomesnegat i
ve.

Tot
alCost

Totalcostisaneconomicmeasur ethatsumsal
lexpensespai
dtoproduceaproduct,pur
chase
aninvestment,oracqui
reapieceofequipmenti
ncl
udingnotonl
ytheini
ti
alcashoutl
aybutalso
theopportuni
tycostofthei
rchoices.

Exampl
eofTot
alCost

Goodear
thI
ndustr
iesi
samanufactur
erofcar
dboar
dboxes.Thecompanyi
ncur
sthef
oll
owi
ng
cost
stomanufact
ureandsel
l100,
000boxes:

Fi
xedmanuf
act
uri
ngcost
s=$250,
000

Var
iabl
emanuf
act
uri
ngcost
s=$650,
000

Sel
l
ingandadmi
nist
rat
ivecost
s=$100,
000

Tot
alcost
s=$1,
000,
000(
$250,
000+$650,
000+$100,
000)

Av
eragecostperbox=$10(
$1,
000,
000di
vi
dedby100,
000)
Goodeart
hsel
lst
heboxesthati
tmanufact
uresatamarkupof25%.Cal
cul
ati
ngi
tst
otalcost
s
al
lowsthecompanyt
oarri
veatit
ssel
li
ngpriceof$12.
50perbox.(
$10+25%of$10).

Fi
xedCost

Fi
xedcost
sarecostst
hatdonotchangewhenthequanti
tyofout
putchanges.Unli
kevari
able
cost
s,whi
chchangewit
htheamountofoutput
,fi
xedcost
sarenotzerowhenpr oduct
ioniszero.

Exampl
es

 Amor t
izat
ion.Thisi
sthegradualchar
gingt
oexpenseofthecostofani
ntangi
bleasset
(suchasapur chasedpat
ent)overtheusef
ull
i
feoftheasset
.

 Depreci
ati
on.Thi
sisthegradualchargingt
oexpenseoft
hecostofat
angi
bleasset
(suchasproduct
ionequi
pment )overtheusef
ull
if
eoftheasset
.

 I
nsur
ance.Thi
sisaper
iodi
cchar
geunderani
nsur
ancecont
ract
.

 I
nter
estexpense.Thisisthecostoff
undsloanedtoabusi
nessbyalender
.Thi
sisonl
y
afi
xedcostifafixedint
erestr
atewasincor
poratedi
ntot
heloanagr
eement.

 Proper
tyt
axes.Thi
sisataxchar
gedt
oabusi
nessbyt
hel
ocal
gov
ernment
,whi
chi
s
basedonthecostofi
tsasset
s.

 Rent
.Thi
sisaper
iodi
cchar
gef
ort
heuseofr
eal
est
ateownedbyal
andl
ord.

 Sal
ari
es.Thisi
saf
ixedcompensat
ionamountpai
dtoempl
oyees,
irr
espect
iveoft
hei
r
hour
swor ked.

 Ut
il
it
ies.Thi
sisthecostofel
ect
ri
cit
y,gas,
phones,
andsof
ort
h.Thi
scosthasav
ari
abl
e
el
ement ,
buti
slargel
yfi
xed.

Var
iabl
eCost

Av ari
ablecostisacostthatchangesinr
elat
iont
ov ar
iationsinanacti
v i
ty.I
nabusi ness,t
he
"acti
vi
ty"isfr
equentlypr
oducti
onv ol
ume,wit
hsalesvolumebei nganotherlikelytr
iggeri
ngevent
.
Thus,themat eri
alsusedasthecomponentsinaproductar econsi
deredv ariablecosts,
becauset heyvarydi
rect
lywit
ht henumberofuni
tsofpr oductmanufactured.

I
tisusef
ult
ounder
standt
hepr
opor
ti
onofv
ari
abl
ecost
sinabusi
ness,
sinceahi
ghpr
opor
ti
on
meanst hatabusi
nesscanconti
nuetofunct
ionatar
elati
vel
ylowsal
esl
evel
.Conversel
y,ahi
gh
proporti
onoffi
xedcost
srequi
resthatabusi
nessmaintai
nahighsal
esl
evel
inordertostayi
n
business.

Exampl
es

 Di
rectmater
ial
s.Themostpur
elyv
ari
abl
ecostofal
l
,thesear
ether
awmat
eri
alst
hatgo
i
ntoaproduct.

 Pieceratelabor.Thi
si stheamountpaidt
owor ker
sforever
yunitcompl
eted(note:
di
r ectl
aborisfrequentlynotav
ariabl
ecost,
sinceaminimum numberofpeopleare
neededt ostafftheproducti
onarea;t
hismakesitafi
xedcost)
.

 Pr
oducti
onsuppli
es.Thingsl
ikemachi
ner
yoilar
econsumedbasedont
heamountof
machi
neryusage,
sot hesecostsv
arywi
thpr
oducti
onvol
ume.

 Bil
l
ablestaffwages.Ifacompanybil
l
soutthet
imeofitsemploy
ees,andthose
employeesareonlypaidift
heyworkbil
l
abl
ehours,
thenthi
sisavari
ablecost.However
,
i
ftheyarepaidsalari
es(wheret
heyarepai
dnomat t
erhowmanyhour stheywork),
then
thi
sisafixedcost.

 Commi ssi
ons.Sal
espeoplear
epai
dacommi
ssi
ononl
yift
heysel
lpr
oduct
sorser
vices,
sothi
sisclearl
yavari
ablecost
.

 Credi
tcar
df ees.Feesar
eonl
ychar gedtoabusi nessi
fitaccept
screditcardpur
chases
fr
om cust
omer s.Onlyt
hecr
editcardfeesthatareapercentageofsales(i.
e.,
notthe
monthlyf
ixedfee)shoul
dbeconsideredvari
able.

 Frei
ghtout
.Abusinessi
ncursashippi
ngcostonlywheni
tsel
l
sandshi
psoutapr
oduct
.
Thus,f
rei
ghtoutcanbeconsider
edav ar
iabl
ecost.

Av
erageCost

Averagecosti
sacostaccount
ingter
mthatissometi
mesr ef
erredtoasuni
tcostorweight
ed
averagecost
.Aver
agecostcanref
ertoei
theraver
agecostofinvent
oryort
heaveragecostof
unit
sproduced.

Thesetwocat egor
iesaresimi
lari
nnat
ure.Retai
l
ersusuall
ydon’tproduceanyoftheiri
nventor
y;
theybuyitfr
om manuf act
urer
sorwhol
esaler
s.Manufactur
ers,
ont heotherhand,producethei
r
owninventory.Ret
ail
ersneedtoknowthecostofwhattheypai
df ortheinv
entory
,whi l
e
manuf
act
urer
sneedt
oknowhowmuchi
tcost
sthem t
opr
oducet
hei
nvent
ory
.

Exampl
e

Ifaretai
l
eraver
aged$20shi
rt
sinwit
h$100shoes,t
heinventoryaverageperuni
twoul
dbea
l
itt
leskewed.Eacht
ypeofi
nvent
oryshoul
dbesepar
atel
yav eraged.Here’
swhattheav
erage
costformul
alooksl
ike:

Amanuf act
urer
’scal
culat
ionofaverageunitcostsisjustassimpl
eastheret
ail
ers’
.Takethe
tot
aldol
l
aramountspendonmanuf actur
ingagr oupofpr oduct
sanddi
videi
tbythetotal
amountofunit
sproduced.Herei
stheav erageunitsequat i
on.

Mar
ginal
Cost

Margi
nalcosti
stheadditi
onal
costincur
redfort
heproducti
onofanaddi
ti
onaluni
tofout
put.
Thefor
mulaiscalcul
atedbydi
vidi
ngthechangeint
het ot
alcostbyt
hechangeint
heproduct
out
put.

Exampl
e

Manufacturi
ngcompanyXmanuf actur
esheatingsy st
ems.Thefactor
’soutdatedexi
sti
ng
equipmentdoesnotmeetthefir
m’smanuf act
uringneedsandcan’tkeepupwi tht
heproduct
ion
schedul
e.Thef i
rm hast
opurchaseorrentaddit
ionalequi
pmenttomai nt
ainit
sproducti
onat
thesamel ev
els.

Thus,t
heaccounti
ngdepar
tmentneedstocalculat
ethemargi
nalcostoftheheati
ngsy
stems
thatwi
llbepr
oducedbythenewequipment,
includi
ngthecostofthei
racqui
sit
ion.
Obser
vat
ions

1.Thetotal
costincr
easesast hequant
it
yoft
hepr
oducti
ncr
easesbecausel
argerquant
it
iesof
product
ionfact
orsarerequi
red.

2.TheMCisreducedupt
oacer
tai
nlev
elofpr
oduct
ion(
Q=5)
,andt
hen,
itkeepsongr
owi
ng
al
ongwit
hproducti
on.

3.TheMCofpr oducinganadditi
onal
uni tofheat
ingsystemsateachlev
elofproducti
onhasto
takei
ntoaccountasuddenincreasei
nt herawmat eri
als.I
fthef
ir
m hastochangeitssuppl
i
ers,
theMCmayi ncreaseduetolongerdi
stancesandhi gherpri
cesofr
awmat er
ial
s.

Expl
i
citCost

Anexpli
citcosti
saphy si
cal
outl
ayofcashorfi
nanci
alexpendit
urethatt
hefir
mr eport
soni t
s
fi
nanci
alstatement
s.Thesecost
spert
aintot
heproducti
onf act
orsthatafi
rm owns,uti
l
izes,
andspendsmoneyf or,
andhaveadir
ectimpactonit
sprofi
tabil
it
y.

Exampl
e

ThemanagerofCompanyXasksPhi l
ip,t
hegeneralaccountant
,tocalcul
atet
heexpl
icitcost
s
foraperi
odoffi
veyears.Themanagerwant stoseeifthecost-
cutt
ingpoli
cyheimpl
ement s
bri
ngs,i
nfact
,anyresul
ts.Phi
l
ipcol
lectstheinf
ormationfr
om 2011t o2015,andhecreatesan
excelf
il
easfol
lows:
Phi
lipfindsoutthatbetween2001and2015, t
hecompany’sexpl
ici
tcostshaveincr
easedby
44.
9%.Themai nincreasesareininvent
oryby8.2%,r
entby11.1%,mortgageby20.0%and
advert
isingby30.1%.Rawmat eri
alshavedecl
inedby1.
7%andwagesby6. 3%,whereasthe
el
ectri
citybi
ll
shav esli
ghtl
yincreasedby2.9%.

Expli
citcostshav eadi rectimpactont hefi
rm’sprofi
tabil
i
ty.Witha45%i ncreaseinexpli
cit
costs,i
tisev identthatthecost -cut
tingpoli
cythatthemanageri mpl ementsi sineff
ecti
ve.
Expli
citcostsneedt obemanagedsot hatt
hef i
rm canincreaseitsprofi
tabil
itybyloweri
ngits
advert
ising,mor tgageandi nv entor
yexpenses.Inthelong-term,themanagerneedst omake
surethatt hecompany ’
sr evenuesremai nstr
ongsot hatinventori
esar esold.Ifontheother
hand,thesal esdecline,thecompanyneedst ocutdownoni nventor
iesandper hapsonstaff
hourstol oweri t
sexplicitcosts.

I
mpl
i
citCost

I
mplici
tcostsarecostsonwhicht
hefir
m wai vesanyopport
unityofear
ningapr
ofi
tfr
om the
useofit
sinter
nalresour
cesbythi
rdpart
ies,suchastherentthatafi
rm woul
dearni
fitl
eased
outabuil
dingthati
townsinst
eadofusingitforit
sownoper ati
ons.

Theyar ealsocostst
hatt hefir
m cannotaccountfor
,suchast hedepreciat
ionofequipmentor
thecostofhi r
inganempl oyee.Forthi
sreason,t
heyarenotr ecor
dedonanyf i
nanci
alstat
ement.
Thesecost saregeneral
lyhardt oquanti
fysi
ncetherei
snophy si
calexchangeofcashor
transacti
ondirect
lyr
elatedtothem; however,
somebusi nessessingl
eoutt heseascostsof
potential
sourcesofincome.

Exampl
e

Amanuf actur
ingcompanyownsabui l
ding,whi
chisusedfori
tsownoperat
ionsinsteadof
rent
ingouttoanotherfir
m.Thecompanyhasanetpr ofi
tof$25,
000permonth,andt he
opport
unitycostofrenti
s$10,
000.Theactualeconomi
cprofi
tofthemanuf
acturingcompany
i
s$25,000–$10, 000=$15,000permont h.

Becauset hefi
rm usesitsownr esources,
itdoesnotear
nincomeont heseasset
s,andi
tcannot
reportanyexpli
citcostsforusi
ngt hebuil
dingfori
tsownoperat
ions.I
ndoingso,t
hecompany
waivesapot ent
ialincomeof$10, 000permont h.
Ifthecompanyearned$13,000f
rom t
herentwit
hanetincomewas$10, 000permont h,i
twoul
d
facealossof$10,000–$13,000=–$3,000.Thi
smeanst hatt
heasseti
sunder ut
il
ized,
andthe
companyshouldrentoutthebui
ldi
ngtoearnanaddi
ti
onalprof
itpermonthinst
eadofusingit
forit
soperat
ions.

Oppor
tuni
tyCost

Anoppor t
unit
ycostistheeconomicconceptofpot
ent
ial
benef
it
sthatacompanygi
vesupby
takinganalt
ernat
iveacti
on.I
notherwords,t
hisi
sthepot
ent
ial
benefi
tyoucoul
dhaver
ecei
ved
i
fy ouhadtakenactionAinst
eadofacti
onB.

Exampl
e

Manager shav etoevaluatealt

ernativ
ecost si
nalmostev er
ymaj orstrat
egybusinessdecision.
Forinstance,assumeamanuf acturerneedstoincreaseproductionandhastodeci dewhet her
toexpandi tsmanufacturi
ngpl antorhireathir
dshiftofworkers.Thebenefi
tofexpandi ngthe
plantwoul dbethatthecompanywoul dhaveextr
acapacityandt heabil
it
ytohi
reat hi
rdshifti
n
thefuture.Thebenefitofhir
ingat hir
dshiftnowisthatthecompanywoul dsavethebui l
ding
costsandr iskofexpandingthepl ant.

Asyoucansee,bothofthesealternati
veshavemut uall
yexclusiv
ebenef
its.Themanagement
hastochooseoneofthesealternati
ves.Aft
ermuchdebat e,
themanagementdeci destosave
cost
sandhireathir
dshiftofwor ker
s.Thealternati
vecostofmanagementhi r
ingat hi
rdshi
fti
s
thei
nabi
li
tytoi
ncreasecapacity
.Thi smightalsoleadtolostproj
ect
sinthef utur
ebecauset he
busi
nesscan’
tproducethem i
nt ime.

Opport
uni
tycostscanbev i
ewedasthepri
ceoni nacti
on.I
not herwords,byacompanynot
t
akinganalt
ernati
veact
ion,t
heyar
emi ssi
ngoutonoppor tuni
tiesorincur
ri
ngalt
ernat
ivecost
s.
I
tcanalsobev i
ewedast hepr
osandconslistofalt
ernat
iveactions.

Mi
xedCost

Ami xedcostisacostthatcontai
nsbot hafixedcostcomponentandavari
ablecost
component.Iti
simportanttounderstandthemi xoft
heseelementsofacost
,sothatonecan
predi
cthowcostswillchangewi t
hdiffer
entlevel
sofacti
vi
ty.Ty
pical
ly
,aport
ionofami xedcost
maybepr esenti
ntheabsenceofal lacti
vit
y,inaddi
ti
ontowhichthecostmayalsoincr
easeas
act
ivi
tyl
evel
sincrease.Asthelevelofusageofamix
edcostit
em i
ncr
eases,
thefi
xed
componentofthecostwi l
lnotchange,whil
ethev
ari
abl
ecostcomponentwi
lli
ncr
ease.The
for
mulafort
hisrelat
ionshi
pis:

Y=a+bx

Y=Tot
alcost

a=Tot
alf
ixedcost

b=Var
iabl
ecostperuni
tofact
ivi
ty

x=Numberofuni
tsofact
ivi
ty