Assignment:
The goal is to support your conclusions with data, and explain the difference between the long run and the short run and how this distinction is important for X keyboard division, the conditions under which the company should exit the keyboard market and why,the conditions that determine the length of the short run for X's keyboard division and the conditions under which the company should shut down production and why. Any help on this subject, or some guidance to a solution would be helpful. Based on my notes, and my income statements, a solution is obtainable.
Marketing Department Report on Market Perceptions of Three X Products
X currently manufactures and markets three products: a computer sound card, an electronic keyboard, and computer software for composing and editing music.
The company's position in the sound-card market is similar to that in the other two. X is a relatively small player in the market and has a market share of about 8 percent. We surveyed several of our customers by telephone and convened small focus groups. Customers tend to think there is little difference among manufacturers in terms of product quality or usefulness. They also indicate a willingness to switch to one of our competitors if they can get a lower price. Customers, except for very few who are in the very high-end market segment, are not prepared to pay premium prices for products that are generally undifferentiated. The price of our sound cards ought to be close to the market price of sound cards, which is about $81 per card. We expect this price to remain stable in the near future.
The market conditions prevailing in the software market are similar. Many firms are selling similar products. Switching costs are low. We expect the market price of music-editing software to remain at about $126.
In terms of the market position for X, similar conditions exist in the keyboard market. However, unlike in the other two markets, the keyboard market has recently suffered from sagging demand, partly because of a deteriorating macroeconomic situation. The market price of keyboards has fallen by almost 20 percent in the past six months, from around $355 to its current level of around $305. It could continue to fall in the future
Interview with Michael Espinosa, VP of Operations
We're selling sound cards for $81 each. For each card we sell, we make a profit equal to this price minus the average cost of producing it. This per-unit profit is the difference between the price and average cost on this graph.
Right now, the company is minimizing the average variable cost of production. I want to convince you that we could do better by minimizing average total cost instead.
Per-unit profit is maximized where the distance between price and average cost is greatest, or where the average cost curve is at its minimum.
The other factor you need to think about is the difference between average cost and average variable cost. Average cost includes each sound card's share of fixed costs, like the mortgage on our factory, as well as its share of variable costs, like the labor and electricity used in production. Consider the quantity that minimizes average variable cost.
At this quantity, average cost is still falling. That means we could make more money on each sound card we sell by increasing production.
This is because fixed costs are high relative to variable costs, and when we spread the fixed costs over a larger number of units produced, it offsets any increase in the average variable cost.
So we're selling more sound cards and making more money on each one we sell when average cost is minimized.
Interview with Rachel Dixon, VP of Marketing
First off, I want to say that I don't necessarily disagree with Michael, but I think he's thinking about things the wrong way.
He is right that both average cost and average variable cost are important terms. But all they really help us do is keep track of profits or losses resulting from our output decision. They're not useful guides for making important decisions.
When we're deciding how many sound cards to produce, we need to think about the marginal effects of our production decisions. We always need to ask ourselves, "Can we increase profits by producing a few more or a few less sound cards?" If we can, then we're not producing at the correct level. I think the fixed costs are really irrelevant to that kind of decision. Let me explain.
You know that the sound-card division's profits are equal to its total revenue minus its total costs.
Total costs include fixed costs and total variable costs. Now, when we increase production, total revenue and total costs increase as well. Whether profit increases or decreases depends on which is growing faster.
The change in total revenue is the price of a sound card, which is $81.
The change in total cost is a change in variable costs. When a change in variable costs accompanies a change in quantity, it is called the "marginal cost."
The price of a sound card and the marginal cost of producing one are what we need to consider when we think about production levels.
This is what I mean by "thinking on the margin."
But what if we cut production? Then both total revenue and total cost would decrease, and we would want to know if one is decreasing faster than the other.
Note that fixed costs don't change with the quantity produced; they just shift total costs up and down. So they don't affect decisions on the margin.
So when we think about maximizing profits, we need to consider the relationship between the price of a sound card and the marginal cost of producing one.
Average costs and average variable costs are important, but they don't help us determine the optimal quantity to produce. Specifically, we want to pick a production level that maximizes the difference between the price of a sound card and the marginal cost of producing one.
This is at the point where the marginal cost curve reaches its minimum.
Operations Department Report on Allocation of X Fixed and Variable Costs
X like most companies, incurs two types of costs in manufacturing its products: fixed and variable. Fixed costs include general administrative costs, promotional and advertising expenditures, research and development costs, and some manufacturing overhead. Variable costs include direct labor, the cost of materials, and the remaining manufacturing overhead. Currently, fixed costs that cannot be attributed directly to one division are assigned on the basis of the percentage of total revenue that the divisions generate. The average cost and average variable cost data at various levels of output are generated from historical data with the aid of engineering cost estimates.
Following are the questions at X: Have its costs been categorized correctly as fixed and variable? What allocation methods have been used to distribute common costs to each of the product groups?
Direct labor and materials seem to have been categorized correctly as variable costs. In addition, advertising/promotion, research and development, marketing research, and other general and administrative costs seem to have been categorized properly as fixed costs. But X's manufacturing overhead and selling costs, detailed below, may require closer examination.
Manufacturing Overhead
Manufacturing overhead consists of the following costs:
Manufacturing Overhead
Cost
Electricity $8,235
Production Set-up $3,660
Repairs and Maintenance $3,110
Indirect Labor $530
Total Manufacturing Overhead $15,535
• Electricity costs are incurred primarily in operating the plant to produce product. Each manufacturing line contains electricity monitors, so most of the electricity can be tracked directly to a production line and then assigned directly to the product produced on that line. The costs that were tracked directly totaled $8,061. These costs were assigned to products as follows: sound card, $2,315; software, $3,982; and keyboard, $1,764. The remaining electricity costs are for general lighting and are incurred regardless of the level of production. These costs are considered common to all products.
• Production set-up costs are tracked directly to production equipment. As X products do not share any production equipment, these set-up costs can be directly assigned to products. Production set-up costs totaling $3,660 for the period can be assigned to products as follows: sound card, $1,051; software, $1,808; and keyboard, $801.
• Repairs and maintenance costs consist primarily of the costs of labor and parts to maintain and repair production equipment. Other minor maintenance and repair costs to maintain the general or common areas of the plant are incurred regardless of the level of production. The production equipment–related maintenance and repair costs are incurred only if the production equipment is running. Production equipment–related maintenance and repair costs are tracked directly to the production equipment and can therefore be assigned directly to products. Maintenance and repair costs totaling $2,929 for the period can be assigned to products as follows: sound card, $841; software, $1,447; and keyboard, $641. Remaining maintenance and repair costs are considered common to all products.
• Indirect labor costs consist of the salary and burden costs of personnel who are responsible for the general upkeep of the production facility. None of these costs can be tracked directly to products and would be incurred regardless of production levels. These costs are considered common to all three product groups.
Incurring common manufacturing overhead costs is most closely related to the production hours for each product. For the period just ended, the production hours by product were as follows:
• Sound card: 4,200
• Software: 5,000
• Keyboard: 800
Selling Costs:
X selling costs consist of the salaries and commissions paid to the sales force. The salary portion, which might be only a small fraction of the salesperson's total compensation, is fixed, and commissions depend on the amount sold. Selling costs for the previous period totaled $4,706, of which fixed salaries totaled $1,770 and commissions $2,936. Commissions are tracked directly to the products sold. Commissions by product for the period are as follows: sound card, $1,243; software, $1,450; and keyboard, $243. Salespeople sell all three products, and the time spent selling each product is relative to the number of units sold.
Memorandum
To: VP of Production
From: Ned Fulanovich, Junior Analyst
Subject: Categorizing Costs
I generally agree with the categorization of costs between fixed and variable in the income statement. For the period, the variable costs for the keyboard, software, and sound-card divisions were reported to be $12,491, $28,271, and $15,793, respectively. Fixed costs were reported for the keyboard, software, and sound-card divisions. Categorization of cost between fixed and variable and distribution of common costs among the three divisions followed standard accounting practice and are explained below.
Direct labor and material costs are clearly identifiable to the products and vary with output. Manufacturing overhead costs totaled $15,535 for the period and consisted of items such as production set-ups, maintenance and repair costs, and electricity, among other things. These costs seem to be affected by the volume of production, and as such, I have treated these costs as variable. I have allocated manufacturing overhead to the products on the basis of the total revenue of each product for the period. Revenues reported for the keyboard, software, and sound-card divisions were $13,725, $35,280, and $19,440, respectively.
Advertising/promotion cost, research and development, marketing research, and other general and administrative costs are fixed and have been identified as such in the income statement. Selling costs at X have remained relatively constant over the past few years. Therefore, I have treated selling costs as fixed as well. It is difficult to attribute these fixed costs to specific products, so I have used the company's practice of allocating common fixed cost on the basis of revenue generated.
I have compiled all of this in the income statement below. The total fixed cost of the company, as defined earlier, includes selling costs, advertising/promotion, research and development, marketing research, and other general and administrative, and equals $7,951. Using the sales percentages above, I have allocated $1,595, $4,098, and $2,258 to keyboard, software, and sound-card division, respectively.
Accounting Income Statement (Before categorization and allocation)
Sound Card Software Keyboard Total
Sales volume 240 280 45 565
Sales revenue ($) 19,440 35,280 13,725 68,445
Less Variable Costs
Direct labor 1,283 2,895 1,682 5,860
Materials 10,097 17,369 7,694 35,160
Manufacturing Overhead
Electricity 2,339 4,245 1,651 8,235
Production set-up 1,040 1,886 734 3,660
Maintenance and repair 883 1,603 624 3,110
Indirect labor 151 273 106 530
Total variable costs 15,793 28,271 12,491 56,555
Variable margin 3,647 7,009 1,234 11,890
Less Fixed Costs
Selling costs 1,336 2,426 944 4,706
Advertising/promotion 168 304 118 590
Research/development 419 760 296 1,475
Marketing research 84 152 59 295
Other general/administrative 251 456 178 885
Total fixed costs 2,258 4,098 1,595 7,951
Net Income (before taxes) 1,389 2,911 (361) 3,939
As you can see from the above income statement, the keyboard division is losing money, and I am concerned about its viability. I plan to study this problem further and would like to share my thoughts with you in the future.
Marketing Department Report on the Keyboard Market
Having conducted considerable market research, we believe the sources of the recent problems in the keyboard market are macroeconomic in nature. Most of our customers are first-time purchasers or are upgrading their keyboards—either way, they consider keyboards to be a luxury item. With macroeconomic conditions deteriorating, this market segment is less likely to make purchases. The result has been downward pressure on prices: In the past six months, the price of X’S keyboards have fallen by more than 15 percent, from $355 to its current level of $305.
Economists think that our current economic slowdown is attributable to normal business cycle fluctuations and that the economy will recover and grow. However, some analysts doubt that that will be sufficient to improve spending on keyboards. They cite the lack of new applications that would induce corporations and individuals to upgrade to newer keyboards. Others disagree with this view and say that some people upgrade their keyboards every three years. Because next year would be the third year in the cycle, these analysts believe demand will recover. Demand, the same analysts believe, will also be spurred by the use of faster chips into keyboards and the availability of new applications.
If the market recovers, then prices should at least remain stable at $305 or rise somewhat, to around $320, or even $335, per keyboard. However, there is a real possibility that, over the next two years, prices will continue to drop. If this were the case, then we would expect them to stabilize at around $290, though there is the possibility that they could fall as low as $275.
This last scenario is not very likely. In fact, we are rather confident that prices will rise at least somewhat in the future. However, we cannot rule out future declines in the price of keyboards
Anne Franklin's Memo on Production Costs and Recategorization
Memorandum
To: VP of Production
From: Anne Franklin, Electric 88 Keyboard Division Manager
Subject: Keyboard Production Costs and Recategorization
I wanted to give you an update from the keyboard division. x currently has 18 months remaining on its lease of the factory space and equipment used to produce keyboards. It cannot sublet the space, and it would be nearly impossible to dispose of the equipment before the end of the lease. X also has two years remaining on a long-term contract with its chip supplier, and the chipmaker is interested in extending the contract for an additional year. There is a chip market in which X could resell these chips at no loss if it chose not to use them in production.
Based on those facts, it was necessary for my division to review our production processes. As a result of our review, we have recategorized our costs as shown in the attached spreadsheet.
I hope this is helpful.
Attachment:- Economic Income Statement.xls