Production Decision Analysis

Israel Akhuetie

Nexford University

ACC2200 Milestone 1

Prof. Joseph Moussa

July 24, 2023

 Production Decision Analysis

Variable Costs are expenses that change in proportion to how much a company produces or

sells.Variable costs decrease or increase depending on changes in a company's manufacturing

activity. They are the opposite of fixed costs, which remain constant irrespective of production

levels. Companies rely on variable costs to control the cost per unit (Team, 2022). For example,

an artist was given a contract to produce 500 original copies of oil painting on paper.

In the first month, the artist was able to produce 100 paintings using materials that he

previously obtained at a lower price of $5. This means that the total variable cost for producing

100 paintings is $5 per unit, which includes the cost of the materials used to produce each

painting.

Total Variable Cost = Cost of Materials * Number of Paintings Produced

Total Variable Cost = $5 * 100

Total Variable Cost = $500

During the second month, the artist had to purchase new materials to complete the

remaining 400 paintings, but the cost of the materials had doubled from $5 to $10. This means

that the total variable cost for producing each painting in the second month was $10 per unit.

Total Variable Cost = Cost of Materials * Number of Paintings Produced

Total Variable Cost = $10 * 400

Total Variable Cost = $4,000

This means that the variable cost per unit for the 400 paintings produced in the second

month is $10, which is the cost of the materials used to produce each painting. To calculate the

total variable cost for the entire production of 500 oil paintings:
Total Variable Cost = Variable Cost for 100 Paintings + Variable Cost for 400 Paintings

Total Variable Cost = $500 + $4,000

Total Variable Cost = $4,500

Therefore, the total variable cost for producing 500 oil paintings in this scenario is $4,500.

Examples of variable costs include raw materials, labor, utilities, commission, or

distribution costs.

Fixed Cost is an expense that is not affected by any decrease or increase in the number of units

produced or sold over a period of time (Srivastav & Vaidya, 2019). It is a type of cost that is not

dependent on the business activity but is mostly recurring expenses such as rent, interest

payments, insurance, and property tax. For example, if you lease an office space, as long as the

business operates in that space, the lease or rent cost remains the same . The formula for

calculating fixed cost is:

Total cost of production – (Variable cost per unit x No. of units produced).

Relationship: Fixed cost do not decrease or increase with a change in the number of units

produced. It remains constant regardless of the amount of output. On the other hand, variable

cost remains the same per unit produced, regardless of the total number of units produced.

Production Volume is a metric used to measure the total quantity of goods a company can

produce over a given period. This metric is typically measured in units, such as the number of
vehicle tires produced by a manufacturer or the number of bottles of water produced by a

bottling plant (Fiix, n.d.).

To track production volume, a production manager may use a spreadsheet or other

technological tools to ensure that products are being manufactured at an appropriate pace and

within specified time frames.

The formula for calculating production volume involves multiplying the number of units

produced by the unit cost, which yields the production volume. For example, if a bakery bakes

50 bread loaves, each costing $3 and sold for $6, the total production volume would be 50 x 3 =

$150 (or 150 units).

It is crucial to track production volume as it is a reliable indicator of a company's

profitability and expenditure. Additionally, it enables accurate budgeting and forecasting of

inventory levels, which can help ensure that the company has an adequate cash balance at any

given point (Fiix, n.d.).

Operating Leverage and Profit:

Operating leverage is a cost-accounting formula that measures the relationship between

fixed and variable costs. A company with high operating leverage has a higher proportion of

fixed costs to total costs, which means it must sell more units to cover its costs. Conversely, a

company with low operating leverage has a higher proportion of variable costs to total costs,

which means it can cover its costs with fewer units sold (Chron Contributor, 2013).

The importance of operating leverage lies in its impact on a company's pricing strategy.

To make profits above the break-even point, a company needs to ensure it has a low operating

leverage.
 The relationship between operating leverage and profit is that higher operating leverage

can lead to higher profits when revenue increases, but it can also lead to lower profits when

revenue decreases. Therefore, a company must balance its fixed and variable costs to ensure that

it has an appropriate level of operating leverage to optimize its profitability.

Contribution Margin is the portion of a company's sales revenue that exceeds its variable

costs. It is calculated by subtracting the variable cost per unit from the selling price per unit. This

measure represents the amount of sales revenue that is not consumed by variable costs.

Business owners rely on contribution margins to make various business decisions,

such as determining which products are profitable and which should be discontinued. By

analyzing the contribution margins for each product line, companies can make informed

decisions about their product offerings.

Contribution margin analysis is also a measure of operating leverage, as it shows how

growth in sales translates to growth in profits. Companies with higher contribution margins can

experience higher profits when sales increase, as more of the sales revenue will translate to

profits after variable costs are covered.

Break-even Point is the point at which a company neither generates a profit nor incurs a loss. To

calculate the break-even point, a company must balance its fixed and variable costs with the

selling price of its products or services. This calculation determines the minimum number of

units a business must sell to break even. The formula for calculating the break-even point is as

follows:

Break-even point = Fixed costs / (Selling price per unit - Variable costs)
 Knowing the break-even point is important for businesses, as it can help them make

informed decisions about pricing, production, and sales strategies. It can also help businesses set

goals and forecast profits.

Operating Profit is a financial metric that represents the total earnings a company generates

from its business operations over a specific period. Operating profit is calculated by subtracting

the total cost of goods sold and operating expenses from the total revenue.

Operating profit does not include the deduction of interest and taxes, making it a useful

metric for evaluating a company's core profitability. It is an important margin to track and a key

financial KPI, as everything used to calculate a company’s operating profit is relevant to the

company’s financial health. The formula for calculating operating profit is:

Operating profit = Total revenue - Cost of goods sold - Operating expenses

 References

Chen, J. (2019). Operating Profit. Investopedia.

https://www.investopedia.com/terms/o/operating_profit.asp

Chron Contributor. (2013). What Effect Does Operating Leverage Have on a Company’s Profits?

Chron.com. https://smallbusiness.chron.com/effect-operating-leverage-companys-profits-

76791.html

Fiix. (n.d.). What Is Production Volume? | Maintenance Metrics. Fiix. Retrieved July 17, 2023,

from https://www.fiixsoftware.com/maintenance-metrics/what-is-production-volume/

MITCHELL, C. (2023, March 16). What Is a Breakeven Point (BEP)? Investopedia.

https://www.investopedia.com/terms/b/breakevenpoint.asp#:~:text=What%20Is%20a

%20Breakeven%20Point

Srivastav, A., & Vaidya, D. (2019, June 6). Fixed Cost (Definition, Formula) | Step by Step

Calculation. WallStreetMojo. https://www.wallstreetmojo.com/fixed-cost-definition/

Team, W. (2022, November 15). Variable Costs. WallStreetMojo.

https://www.wallstreetmojo.com/variable-costs/
Wikipedia Contributors. (2019, March 29). Contribution margin. Wikipedia; Wikimedia

Foundation. https://en.wikipedia.org/wiki/Contribution_margin