Clear Hear Manufacturing: Fixed and Variable Costs

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Table of Contents

Introduction
Fixed and Variable Cost
Minimum Efficient Scale
Economies and Diseconomies of Scale
Conclusion
References

Introduction

Clear Hear Manufacturing seems to be a company that has been in the business of manufacturing for few years given that it is still yet to obtain a stable market share of it clients. This is evidence from the fact that the company has an excess of 70,000 cell phones that are yet to be sold.

It also appears to be a relatively small company given that the only employee that we encounter in the case scenario is Lisa Norman who is the production manager; in fact this major decision of approving the ideal production level for the company is delegated to her while it is normally taken up by more senior executives in large companies.

Finally the company appears to be guided by best business practices that are well captured and outlined in its three mission statement, which we find Lisa Norman contemplating in this case scenario.

Fixed and Variable Cost

In principal fixed cost are expenses that are not influenced or affected by the scale of services or goods that a company undertakes such as rent, utilities and employee salaries (Gelles and Douglas, 1996). Variable costs on the other hand are company expenses that vary with change in scale of company operations such as overtime employee allowances and transport costs among others (Gelles and Douglas, 1996).

Variable costs are therefore considered to be expenses that are incurred during product manufacturing or during sales of services or goods; in this case it will be the costs that are associated with the increased production level of the Alpha model phones that Lisa is considering to produce.

However for simplicity purposes variable costs are taken to be all types of expenses that tend to fluctuate with levels of business operations, this way it is much easier to separate fixed cost from variable costs.

According to financial principles, what is needed to be done to lower the cost of production in this case is to significantly reduce the variable cost while effectively utilizing the fixed cost that the company must meet. This concept is well captured by the Minimum Efficient Scale (MES) which is most suitable for determining the ideal production level of a company at which production is most cost efficient.

Minimum Efficient Scale

Minimum Efficient Scale (MES) is a concept primarily used in industrial organization to describe a point in production whereby a manufacturing plant produces the least amount of units that are able to minimize the Long Run Average Costs (LRAC) of the plant (MacAuliffe, 2004).

It is the point where minimum efficient scale of a plant is attained since the least production of units at the lowest opportunity cost is attained, below this point a plant is not able to produce goods and meet the long run average costs of the plant. It is usually indicated as the first point of the LRAC curve when the variables of production and costs are graphically represented.

The minimum efficient scale concept is also used to determine the point at which the maximum effectiveness of the plant is attained (McConnell, Brue and Flynn, 2009). Ideally since the minimum efficient scale is a specific point in the production curve its value is often expressed quantitatively as an exact figure; nevertheless it can take various ranges as well as values (Frisch, 1980).

This is because the long run average cost (LRAC) curve is basically influenced by two major variables: economies of scale and diseconomies of scale (Frisch, 1980).

Hence minimum efficient scale is not necessarily a single value of quantity but may also include range of values for which the point of minimum efficient scale can be said to occur.

Economies and Diseconomies of Scale

Normally in estimation of MES the long run average cost curve is usually L-shaped since manufacturing industries has substantial low-end economies of scale that eventually get exhausted rapidly (Ferguson, 1990). The result is that average costs for production remain constant for all firms in the industry. Hence the L-curve design of long run average cost implies that MES is a concept that mainly defines the lower end limits of plant size as well as the high bound limits.

Fig 1: Long-run Average total cost curve

Long-run Average total cost curve

As indicated in the curve above the cost of production for a firm reduces with increasing output of the plant up to a certain level, thereafter further increase of output leads to increased cost in production since it is at this point that diseconomies of scale sets in (AmosWeb.com, 2009).

Prior to that, the firm is efficient because of various returns on scale such as managerial economies, technical economies, marketing economies and purchasing economies (McConnell et al, 2009). Ultimately the various factors that determine production cost for firms tend to vary in the long run since plants must determine the choice of approach that they must opt to attain the optimum production level.

MES point for Clear Hear manufacturing company

The concept of MES that we have discussed will now enable us determine the point at which maximum production levels should be capped at for Clear Hear Company, which is the maximum efficient scale.

To determine this let us now look at the current units of production and their prices. Under the present circumstances Lisa Norman cannot afford to do business with Big Box given the maximum price that they are willing to pay is $15, while the cost of production for Alpha model is $18.

This means there are two options for Lisa, to significantly reduce the total cost incurred in production of the Alpha model below the $15 mark in order to make profits, or consider the OEM offer that would enable her produce the Alpha prototype at $14 thereby enabling her to make a $1 profit.

At the current production level of 70,000 units it is unlikely that increased plant output at 100,000 would be large enough to significantly reduce the total costs up to a point that would increase the profit margin beyond the present $1. This is because increasing production levels in a company is essentially expensive in the short term, even though it has the advantages of economies of scale in the long term.

Unfortunately there is no enough data in this case scenario that would enable calculation of change in total cost as production levels of Alpha model cell phones are increased to 100,000 units. Option two would be most favorable since it will increase the cost output of the Clear Hear Company to a level that would enable it maximize on the economies of scale.

With the $14 price tag that is being offered by the OEM, Lisa Norman can further increase the profit margin by lowering the variable cost incurred in the production of the Alpha model prototype and thereby increase the profit margin beyond the projected $1. It would also enable maximum utilization of the plant thereby enabling Lisa Norman to qualify for bonuses from both ends; high sales volume and optimal plant utilization.

Table 1

Unit Profitability Report
Alpha Model	Alpha Model	Beta Model
Price per Unit	20	30
Variable cost per unit	8	12
Fixed overhead	9	10
Profits	3	8

Conclusion

In conclusion Lisa Norman should opt to choose the OEM offer which will enable her produce the required units of Alpha model prototype since it provides higher return levels. This is because average cost per unit is calculated by dividing the total cost (fixed + variable) by the number of products produced; to reduce the total costs there are two options that are open for Lisa regarding this approach.

To reduce the variable cost, since fixed costs cannot be reduced, or to increase production of Alpha model cell phones to a level that would lower the overall total cost; she should choose to do both. However, all other factors being constant foregoing the production of 30, 000 Beta model and producing the 100,000 Alpha model prototype will be a cost effective alternative. This is especially the case since the cost of production that is associated with manufacture of the Beta model is significantly higher than production of Alpha model.

References

AmosWeb.com, (2009). Minimum Efficient Scale. Web.

Gelles, G. and Douglas, W., (1996). Returns to Scale and Economies of Scale: Further observations. Journal of Economic Education, 27(5): 259-261.

MacAuliffe, R. (2004). Minimum Efficient Scale. Web.

McConnell, C., Brue, S. & Flynn, S., (2009). Economics: Principles, Problems and Policies. 18th ed. New York, NY: Mcgraw-Hill Irwin.

Frisch, R., (1980). Theory of Production. California, CA: Drodrecht Press.

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