9781118041581

it improve its profits? First, consider the wrongmethod of approaching these questions.

Management observes that when it sells 2,400 pairs, total average cost is $39.65 per pair.

This exceeds the $36 selling price. Therefore, management believes its current strategy is

unprofitable. What are its other options? An obvious possibility is to increase price to a

level above $39.65, say, to $40. The table shows the results of this strategy. Volume drops to

1,600 pairs, but average total cost rises to $50.88. (Because the decline in volume is much

greater than the reduction in total cost, average cost rises dramatically.) Price still falls well

short of average cost. A price cut will do no better. The other prices in the table tell the

same story: Average total cost exceeds price in all cases. Therefore, management concludes

that the boys’ running shoe cannot earn a profit and should be discontinued.

Let’s now adopt the role of economic consultant and explain why management’s

current reasoning is in error. The problem lies with the allocation of the $90,000 in

“shared” costs. Recall the economic “commandment”: Do not allocate fixed costs. In a

multiproduct firm, contribution is the correct measure of a product’s profitability. A com-

parison of columns 3 and 4 in the table shows that the boys’ shoe makes a positive con-

tribution for four of the price and output combinations. Thus, the shoe should be

retained. The firm’s optimal strategy is to lower the price to P $32. The resulting sales

volume is Q 3,200. Maximum contribution is $102,400 $85,600 $16,800. Beyond

P $32, however, any further price reduction is counterproductive. (The additional cost

of supplying these additional sales units exceeds the extra sales revenue.) Thus, the pro-

duction manager would be wrong to advocate a policy of minimizing direct costs per unit

of output. We can check that of the five output levels, average variable cost (AVC) is min-

imized at Q 4,000. (Here AVC is $100,000/4,000 $25 per pair.) Nonetheless, this vol-

ume of output delivers less contribution than Q 3,200 because the accompanying drop

in price is much greater than the decline in average variable cost. To sum up, the firm’s

correct strategy is to maximize the product’s contribution.

SUMMARY

Decision-Making Principles

1. Cost is an important consideration in decision making. In deciding
   among different courses of action, the manager need only consider the
   differential revenues and costs of the various alternatives.


2. The opportunity cost associated with choosing a particular decision is
   measured by the forgone benefits of the next-best alternative.


3. Economic profit is the difference between total revenues and total costs
   (i.e., explicit costs and opportunity costs). Managerial decisions should
   be based on economic profit, not accounting profit.


4. Costs that are fixed (or sunk) with respect to alternative courses of
   action are irrelevant.


5. In the short run, the firm should continue to produce as long as price
   exceeds average variable cost. Assuming it does produce, the firm

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