Solution Manual for Managerial Economics Applications, Strategies and Tactics, 13th Edition

Solution Manual for Managerial Economics

Applications, Strategies and Tactics, 13th Edition

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 Chapter 8/Cost Analysis

Chapter 8

Cost Analysis
Solutions to Exercises

1. USAir should not build the training center at this location. The true "opportunity" cost of
the land is $2,500,000. We know that the project is unacceptable for any land cost over
$850,000. USAir would be better off selling the land for $2,500,000 and building the
training center elsewhere.

2. Howard Bowen’s cotton farm analysis appears below.

a. Accounting profits:
Revenues $5,000,000
Less: Variable operating costs 4,500,000
Less: Depreciation 40,000
Less: Wages 50,000
Equals: Operating Income $410,000
Less: Interest expense 400,000
Accounting income before tax +$10,000

b. Economic profits:
Revenues $5,000,000
Less: Variable operating costs 4,500,000
Less: Opportunity value of Bowen's income potential 30,000
Less: Economic depreciation 60,000
Equals: Economic profit before financial costs $410,000
Less: Interest expense 400,000
Less: Opportunity cost of net $1 million equity @10% 100,000
Equals: Economic profit, or (loss) ($90,000)

If these calculations are representative of Bowen's regular performance, he would be

better off financially by selling the farm and working for someone else. This analysis
ignores many intangible factors that may affect Bowen's decision.

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or posted to a publicly accessible website, in whole or in part.
 Chapter 8/Cost Analysis

3. Mary Graham’s work at Piedmont Properties.

a. Pro forma Accounting pre-tax profits for the first year:

Revenues $2,000,000
Less: Salaries 1,500,000
Operating expenses 250,000
Depreciation 5,000
Total 1,775,000
Operating income 245,000
Less: Interest expense 75,000
Accounting profit before tax $170,000

b. Pro forma Economic pre-tax profits for the first year:

Revenues $2,000,000
Less: Salaries 1,500,000
Operating expenses 250,000
Depreciation 20,000
Graham's foregone income 100,000
Total 1,870,000
Economic profit before financial costs 130,000
Less: Interest expense 75,000
Economic profit before tax $55,000

c. Explicit costs⎯salaries, operating expenses, depreciation for tax purposes ($5,000),

and interest expenses.

Implicit costs⎯Graham's foregone income and additional depreciation ($15,000 =

$20,000 − $5,000).

Note that Mary Graham would decide to start the new real estate agency using accounting
data, because it produces more than her current $100,000 income. But, she would more
likely decide to continue to work for Piedmont Properties using the economic data.

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© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
 Chapter 8/Cost Analysis

4. Complete the table. Bold figures reflect the given values.

Q TC FC VC ATC AFC AVC MC

0 125 125 0 - - - -
10 175 125 50 17.50 12.50 5.00 5.00
20 210 125 85 10.50 6.25 4.25 3.50
30 235 125 110 7.83 4.17 3.67 2.50
40 255 125 130 6.38 3.13 3.25 2.00
50 275 125 150 5.50 2.50 3.00 2.00
60 305 125 180 5.08 2.08 3.00 3.00
70 350 125 225 5.00 1.79 3.21 4.50
80 420 125 295 5.25 1.56 3.69 7.00

5. Operating expenses rise above 80% capacity (800 units), with AFC at $50 at 800 units.
Accordingly, FC = $40,000. AVC is $100 at 800 units, so VC is $80,000 at 800 units. Complete
the table for examining cost curves.

Q TC FC VC ATC AFC AVC MC

500 90000 40000 50000 180.00 80.00 100 ---
600 100000 40000 60000 166.66 66.66 100 100.00
700 110000 40000 70000 157.14 57.14 100 100.00
800 120000 40000 80000 150 50 100 100.00
900 139000 40000 99000 154.44 3.13 110 190.00
1000 165000 40000 125000 165.00 12.50 125 260.00
1100 205000 40000 165000 186.36 1.79 150 400.00

6. The Blair Company has multiple plant locations.

a. One centralized plant in Missouri:

TC = $900,000 + (6,000 + 4,500 + 3,000) $250 = $4,275,000
Three subassembly plants:
TC = ($475,000 + $425,000 + $400,000) + (6000 + 4500 + 3000) $225 = $4,337,500
One centralized plant would be cheaper.

b. One centralized plant at full capacity:

TC = $900,000 + (18,000)$250 = $5,400,000
Three plants: TC = ($475,000 + $425,000 + $400,000) + (8,000 + 6,000 + 4,000)$225
= $5,350,000.
Three plants should be built.

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© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
 Chapter 8/Cost Analysis

c. It would be helpful to have a credible forecast of the future demand for

subassemblies.

7. Kitchen Helper Company is considering different types of plant facilities.

a. Plant A Plant B Plant C___

Output TC ATC TC ATC TC ATC__

25000 150000+9(25000)=$375000 $15.00 $450,000 $18.00 $625,000 25.00
50000 150000+9(50000)=600,000 12.00 650,000 13.00 800,000 16.00
75000 150000+9(75000)=825,000 11.00 850,000 11.33 975,000 13.00
100000 300000+9(100000)=1,200,000 12.00 1,050,000 10.50 1,150,000 11.50
125000 300000+9(125000)=1,425,000 11.40 1,250,000 10.00 1,325,000 10.60
150000 300000+9(150000)=165,0000 11.00 1,450,000 9.67 1,500,000 10.00
175000 450000+9(175000)=2,025,000 11.57 1,900,000 10.86 1,67,5000 9.57
200000 450000+9(200000)=2,250,000 11.25 2,100,000 10.50 1,850,000 9.25
225000 450000+9(225000)=2,475,000 11.00 2,300,000 10.22 2,025,000 9.00
250000 600000+9(250000)=2,850,000 11.40 2,500,000 10.00 2,200,000 8.80
275000 600000+9(275000)=3,075,000 11.18 2,700,000 9.82 2,375,000 8.64
300000 600000+9(300000)=3,300,000 11.00 2,900,000 9.67 2,550,000 8.50
325000 750000+9(325000)=3,675,000 11.31 3,350,000 10.31 2,725,000 8.38
350000 750000+9(350000)=3900000 11.14 3,550,000 10.14 2,900,000 8.29

b. Output ____ ATC

25,000 $15.00(A)
50,000 12.00(A)
75,000 11.00(A)
100,000 10.50(B)
125,000 10.00(B)
150,000 9.67(B)
175,000 9.57(C)
200,000 9.25(C)
225,000 9.00(C)
250,000 8.80(C)
275,000 8.64(C)
300,000 8.50(C)
325,000 8.38(C)
350,000 8.29(C)

The long run ATC is declining in output volume.

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or posted to a publicly accessible website, in whole or in part.
 Chapter 8/Cost Analysis

8. ARA should not build the maintenance facility at this location. The true "opportunity"
cost of the land is $1,000,000. We know that the project is unacceptable for any land cost
over $500,000. ARA would be better off selling the land for $1,000,000 and building the
maintenance facility elsewhere.

9. The Emerson Corporation finds that there is learning by doing in airplane landing gear
equipment. The estimated cost of the 200th unit is Log C = 3.30755 - .28724 Log(200) =
3.30755-.28724(2.301) = 2.6466, so the antilog of this is 10 2.6466 = $443.20.

[Note: It was apparent that Emerson used base-10 logarithms rather than natural
logarithm by trying 75 units and finding the result was closest to the log versus the ln fit].

The percentage of learning is [1 – (C2/C1)100%]. The cost per unit is compared at a

doubling of output. We are given 25, 75, and 125, which are not examples of doubling.
We could “interpolate” between 25 and 75 for what 62.5 might have cost (which is half
of 125), or we could use the estimated fit to find a doubling amount.

At 150 units, the estimated per unit cost would be $481.38. From 75 to 150 is a doubling
of output: [1 – (481.38/600)100%] = 19.77% percentage of learning.

Solution to Case Exercise: Cost Analysis

1. Incremental costs per chair for Leisure Products are equal to the variable costs, consisting
of direct labor ($2.25) and materials ($2.30), for a total of $4.55 per chair in incremental
costs.

2. It was assumed that all of plant overhead and administrative and selling expense were
fixed costs. One would like to know what portion of these costs (if any) represents
variable costs. For example, part of plant overhead, such as power and supplies, may
vary with the output level. Likewise, part of the selling costs (e.g., billing) may
constitute variable costs.

3. Based on incremental economic reasoning, the Southeast order should be accepted since
the price ($5.50) exceeds the calculated variable costs ($4.55). The order will contribute
approximately $28,500 (($5.50 − $4.55)  30,000) to the profits of the firm.

4. One would have to consider the long-run impact on the firm of accepting the order. For
example, if other customers find out the LP is selling chairs considerably below the
standard quoted price of $7.15, these other customers may begin demanding lower prices

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or posted to a publicly accessible website, in whole or in part.
Solution Manual for Managerial Economics Applications, Strategies and Tactics, 13th Edition

Chapter 8/Cost Analysis

on their orders. The net effect could be lower prices for all customers and lower profits
for LP.

Solution to Case Exercise: Profit Margins on the Amazon Kindle

1. Variable costs ($35 display screen, $25 touchscreen, $11 assembly labor, $12 battery,
$18 processor chip, $5 DRAM memory chip, $37 software licenses, $8 8 GB memory
module, $6 wireless WIFI/Bluetooth, $34 hardcase) = $191.

Fixed costs allocated to the individual Kindle reader ($7 advertising campaign, $12
R&D expense, $14 overhead) = $33.

Contribution margin (CM) = ($199 - $191) / $199 = .040 (4 percent).

2. Handsets would tend to have higher margins than Kindles for several reasons:

(1) Samsung, RIM and Nokia have realized volume discounts on the purchase of
their electronic and other inputs, lowering variable costs, thereby raising their handset CMs.

(2) Samsung, RIM, and Nokia have experienced such long production runs that
learning curve suggestions have lowered their variable costs thereby raising their CMs.

(3) Customer loyalty to RIM and Nokia handsets raises switching costs, reducing the
price elasticity of demand, and increasing their CMs.

(4) Handsets offer value-added features that Kindle readers do not such as
telecommunications and photo transfer, thereby raising their CMs.

3. Apple iPads would have still higher margins for all the reasons above plus the brand
premium in Apple prices, thereby raising margins. Branding expenses are enormous but these
are fixed costs recovered by higher margins.

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