Operations Decision

At certain times a company that produces a tangible product may have to decide if that company can continue operations and profit or if it has reached the shutdown point. Shutting down is different than going out of business; the company is simply temporarily stopping production because it would cost more to continue with production. As a management consultant hired to assist with this decision, one must consider costs associated with the production.

Factors that will have the greatest impact on this decision are labor costs, fixed costs, and variable costs. Labor costs are costs associated with the work force; fixed costs are costs that will remain constant given any factor of output; and variable costs are costs associated directly with the level of output (labor is part of variable costs).

Company management with the assistance of the hired consultant will consider external environmental factors of supply and demand, competition, efficiency and any possible constraints. Overall a for-profit company strives to maximize profits while keeping costs as low as possible; but in the short-run the company must determine if that company can at least cover variable costs at a given level of production and in the long-run cover total costs (variable and fixed) and still make a profit.

Fashion Watches is a company that produces women’s inexpensive fashion watches. The watches have bands made from latex and colorful faces that include cubic zirconia. The watches come in all variations of color and watch face designs (placement of CZs). The watches are offered at reasonable rates with the idea that women will buy multiple watches to match many different outfits and clothing combinations.

Fashion Watches currently employs at the Erie, Pennsylvania factory 100 workers that produce 6000 units (watches) per month or 300 units per day; the workers work 20 days per month. The daily worker wage is $70 per person and the unit price of the watches is $32. Costs that management must also consider: variable costs of $2,000 per day and the marginal cost per unit is $30.

Given the information that management has an evaluation of the current financial performance can easily be determined for the short-run:
Daily Worker’s Output:(6000/20 days)/100 = 3 units/worker/day Monthly Revenue: 6000 x $32 = $192,000
Employee Daily Wages: 100 workers x $70/day = $7000
Monthly Wages: 20 days/month x $7000 = $140,000
Variable Monthly Costs: $2000/day x 20 days = $40,000
TVC = $180,000
Profit= $12,000
or
Marginal Costs consideration:
Monthly Revenue: 6000 x $32 = $192,000
Marginal Cost: 6000 x $30 = $180,000
Profit = $12,000

Using the calculations from the above two scenarios of cost the company should continue production because short-term determination shows that total revenue is covering the variable costs and marginal costs considerations.

Given the information management can also make an evaluation of possible long-term financials:
Average Total Cost Per Unit:9000 + 300/300 = $31/unit
Even in the long-run the company is making a profit based on a per unit basis given that the unit cost is $32 which is greater than the ATC of $31.
Assuming that the company Fashion Watches is part of a perfectly competitive market, which means that all suppliers of this type of good make identical goods in terms of both cost and quality; the company can then maximize or increase profit by adjusting the variable costs. If the company looks to improve technology and therefore can increase the individual worker’s daily production output to 6500 units per month instead of 6000:

Daily Worker’s Output Increase:(6500/20 days)/100 = 3.25 units/worker/day
Variable Costs (stay the same): $187,000
Total Revenue increase:$208,000
Profit: $21,000
The increase in worker production without adding overtime costs increases the profit in the short-run which takes into consideration variable costs only. If demand stays high the company may also want to consider raising the price per unit. However since Fashion Watches operates in a perfectly competitive market and if no other suppliers raise prices Fashion Watches could lose revenue in the short-run if the company considers changing the price; ultimately the company is better off finding a way to increase worker productivity.

Fashion Watches should consider shutting down if the Average Total Cost per unit becomes higher than the unit selling price of $32. Another scenario that the company should consider shutting down is if in the short-term consideration labor costs make the variable costs increase when trying to increase productivity; for example if to increase to 6500 units per month the company has to pay overtime instead of finding a way to increase efficiency without increasing variable costs. Fashion Watches has reached the shutdown point when the company’s total revenue just covers the variable costs. If the price of the unit equals the average variable cost the company is losing money. A business especially a new business would be wise as part of an analysis to consider the company’s break-even point, which will allow management to determine how much, must be sold monthly and annually to determine the amount necessary to cover costs.

Resources

Berry, T. Break-Even Analysis. Retrieved on February 16, 2013 from http://www.businessknowhow.com/startup/break-even.htm.

McGuigan, J. R., Moyer, R. C., & Harris, F. H. D. (2011). Managerial economics: Applications, strategy, and tactics (12th ed.). Mason, OH: South-Western Cengage Learning.

Shut-down point – American business (2010). Retrieved on February 17, 2013 from http://american-business.org/751-shut-down-point.html.