assignment by me..for managerial economics..

1. MANAGERIAL ECONOMICS
Quiz 01] what is marginal analysis?
Marginal analysis, quite simply, balances the additional benefits from an action against the
additional cost. In any case, be it a firm deciding whether or not to expand production, a
student deciding if another beer is a good idea, or a professor choosing to give an extra exam,
optimal performance requires that benefits and costs be equilibrated on the margin. What this
means is that if the additional benefit exceeds the additional cost, take the action. Keep taking
it as long as the benefit exceeds the cost, and to ensure that all excess benefits (those that
exceed costs) are accrued, do it until for the last action, the benefits just equal the costs.
Marginal Costs
Marginal Costs are the additional costs imposed when one more unit is produced. If the cost
of making 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, the marginal
cost of producing the tenth piece of pizza is $20. The table below illustrates the relationship
between production, total costs,and marginal costs. Notice that total costs always rise as
production increases even though marginal costs may not rise.
Total Marginal
Quantity
Cost Cost
0 0 --
1 5 5
2 10 5 Marginal costs tend to
3 17 7 rise as production
increases. One
4 25 8
explanation for this is
5 34 9 that when a firm grows
6 44 10 very large, it becomes
more and more difficult to manage the organization and costs
7 58 14
rise. Another possibility is that producing more and more of a
8 73 15 particular product becomes more difficult due to technology or
9 90 17 resource limitations. When trying to clean up the air, for
10 110 20 example, the first efforts are relatively inexpensive. A law can
mandate, for example, that the dirtiest cars be taken off the
road. But as one tries to make the air cleaner and cleaner, more
expensive technology is needed. Therefore, marginal costs rise. The rise in Marginal Costs is
shown in the chart above.
Marginal Benefits
Marginal Benefits are the additional benefits received when one more unit is produced.
Benefits can be expressed in terms of units of utility or satisfaction, or sometimes they can be
expressed in dollar amounts. The table below charts the marginal and total benefits from
consuming pieces of pizza. The utility units are expressed in dollar terms.
1|P a g e

2. MANAGERIAL ECONOMICS
Good or service
Total Marginal increases. Notice that
Quantity
Benefits Benefits the marginal benefit
0 0 -- from the second piece of
1 30 30 pizza is 25 units, but the
marginal benefit of the
2 55 25 tenth piece is only 2
3 75 20 units. This is because
4 90 15 the first few pieces of
pizza are very
5 103 13 appetizing when one is
6 113 10 hungry. But with each additional piece, the added benefits to
7 121 8 the person diminish.
8 126 5 Generally speaking, the marginal benefits curve slopes
9 130 4 downward because we tend to like variety and too much of the
10 132 2 same thing gets very old. For instance, when we are used to
breathing filthy air and that air has been cleaned for the first
time, the health benefits are large. But when one breathes relatively clean air already and that
air is made even cleaner, the health benefits are not as dramatic. The chart of total and
marginal benefits above demonstrates this concept.
Economic Efficiency
Economic efficiency in our pizza example occurs
where the MB and MC curves intersect. This occurs at
a quantity of six pieces of pizza.
In general, the efficient level of output is where the
Marginal Benefits just equal the Marginal Costs (point
Q*). This is also the level at which the principle of
utilitarianism holds. Why is this case?
If production is less than Q*, for example at Q L, then society could benefit overall by
producing more. This is because the gains to society (measured by marginal benefits) exceed
the costs to society (measured by marginal costs). There will be a net gain to society of the
difference between the marginal benefits and the
marginal costs.
If production is greater than Q* at Q H, then society
could benefit by producing less. This is because when
we reduce output, the costs imposed on society fall by
more than the fall in marginal benefits. Therefore, the
greatest good for the greatest number occurs at the
intersection of marginal costs and marginal benefits.
Sometimes, the marginal benefits and costs are not
"continuous"and we must make decisions about entire
projects based upon cost/benefit analysis. Suppose the courts must decide whether or not to
allow hundreds of acres of old-growth redwoods to be logged. One could do a cost/benefit
2|P a g e

3. MANAGERIAL ECONOMICS
analysis to determine what the benefits are to society for harvesting the timber versus the
benefits for not harvesting the timber and preserving the forest and the ecosystems. The
efficient outcome would be to cut the trees until marginal benefits equal marginal costs. This
result may not be possible, however, if an all or nothing decision must be made. The recent
compromise in the Headwaters Forest in which most old growth was preserved but other
lands and cash were traded in return, certainly did not please either side completely, but
perhaps the result was more efficient (but not necessarily more fair) than a solution that
allowed the entire area to be harvested, or a decision to ban production completely. The
example over logging demonstrates that the costs and benefits arenot always easily
transferable into dollars. This makes the decisions very difficult and inherently more
subjective.
MARGINAL COST
In economics and finance, marginal cost is the change in total cost that arises when the
quantity produced changes by one unit. That is, it is the cost of producing one more unit of a
good. Mathematically, the marginal cost (MC) function is expressed as the first derivative of
the total cost (TC) function with respect to quantity (Q). Note that the marginal cost may
change with volume, and so at each level of
production, the marginal cost is the cost of the next
unit produced. A typical Marginal Cost Curve
In general terms, marginal
cost at each level of production includes any
additional costs required to produce the next unit.
If producing additional vehicles requires, for
example, building a new factory, the marginal cost
of those extra vehicles includes the cost of the new
factory. In practice, the analysis is segregated into short and long-run cases, and over the
longest run, all costs are marginal. At each level of production and time period being
considered, marginal costs include all costs which vary with the level of production, and
other costs are considered fixed costs.
A number of other factors can affect marginal cost and its applicability to real world
problems. Some of these may be considered market failures. These may include information
asymmetries, the presence of negative or positive externalities, transaction costs, price
discrimination and others.
Cost functions and relationship to average cost-In the simplest case, the total cost
function and its derivative are expressed as follows, where Q represents the production
quantity, VC represents variable costs, FC represents fixed costs and TC represents total
costs.
Since (by definition) fixed costs do not vary with production quantity, it drops out of the
equation when it is differentiated. The important conclusion is that marginal cost is not
3|P a g e

4. MANAGERIAL ECONOMICS
related to fixed costs. This can be compared with average total
cost or ATC, which is the total cost divided by the number of
units produced and does include fixed costs.
For discrete calculation without calculus, marginal cost equals the change in total (or
variable) cost that comes with each additional unit produced. For instance, suppose the total
cost of making 1 shoe is $30 and the total cost of making 2 shoes is $40. The marginal cost of
producing the second shoe is $40 - $30 = $10.
Marginal cost is not the cost of producing the "next" or "last" unit. As Silberberg and Suen
note the cost of the last unit is the same as the cost of the first unit and every other unit. In the
short run increasing production requires using more of the variable input - conventionally
assumed to be labor. Adding more labor to a fixed capital stock reduces the marginal product
of labor because of the diminishing marginal returns. This reduction in productivity is not
limited to the additional labor needed to produce the marginal unit - the productivity of every
unit of labor is reduced. Thus the costs of producing the marginal unit of output has two
components: the cost associated with producing the marginal unit and the increase in average
costs for all units produced due to the “damage” to the entire productive process (∂AC/∂q)q.
The first component is the per unit or average cost. The second unit is the small increase in
costs due to the law of diminishing marginal returns which increaes the costs of all units of
sold.[1] Therefore, the precise formula is:
MC = AC + (∂AC/∂q) q.
Marginal costs can also be expressed as the cost per unit of labor divided by the marginal
product of labor.
MC = ∆VC∕∆q;
∆VC = w∆L;
MC = w∆L;/∆q;
∆L∕∆q the change in quantity of labor to affect a one unit change in output = 1∕MPL.
Therefore MC = w∕MPL SInce the wage rate is assumed constant marginal cost and marginal
product of labor have an inverse relationship - if marginal cost is increasing (decreasing) the
marginal product of labor is decreasing (increasing).
Marginal Costs not affected by changes in fixed cost
Marginal Costs are not affected by changes in fixed cost. Marginal costs can be expressed as
∆C(q)∕∆Q. Since fixed costs do not vary with (depend on) changes in quantity, MC is
∆VC∕∆Q. Thus if fixed cost were to double MC would not be affected and consequently the
profit maximizing quantity and price would not change. this can be ilustrated by graphing the
short run total cost curve and the short run variable cost curve. The shape of the curves are
identical. Each curve initially increases at a decreasing rate reaches and inflection point then
increases at a decreasing rate. the only difference between the curves is that the SRVC curve
4|P a g e

5. MANAGERIAL ECONOMICS
begins from the origin while the SRTC curve originates on the y-axis. The distance of the
origin of the SRTC above the origin represents the fixed cost - the vertical distance between
the curves. This distant remains constant as the quantity produced Q increases. MC is the
slope of the SRVC curve. A change in fixed cost would be reflected by a change in the
vertical distance between the SRTC and SRVC curve. Any such change would have no effect
on the shape of the SRVC curve and therefore its slope at any point - MC.
Externalities
Externalities are costs (or benefits) that are not borne by
the parties to the economic transaction. A producer
may, for example, pollute the environment, and others
may bear those costs. A consumer may consume a good
which produces benefits for society, such as education;
because the individual does not receive all of the
benefits, he may consume less than efficiency would
suggest. Alternatively, an individual may be a smoker or alcoholic and impose costs on
others. In these cases, production or consumption of the good in question may differ from the
optimum level.
Negative Externalities of Production
Much of the time, private and social costs do not
diverge from one another, but at times social costs
may be either greater or less than private costs. When
marginal social costs of production are greater than that of the private cost function, we see
the occurrence of a negative externality of production. Productive processes that result in
pollution are a textbook example of production that creates negative externalities.
Such externalities are a result of firms externalising their costs onto a third party in order to
reduce their own total cost. As a result of externalising such costs we see that members of
society will be negatively affected by such behavior of the firm. In this case, we see that an
increased cost of production on society creates a social cost curve that depicts a greater cost
than the private cost curve.In an equilibrium state we see that markets creating negative
externalities of production will overproduce that good. As a result, the socially optimal
production level would be lower than that observed.
Cost Functions
Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
FC = 420
VC = 60Q + Q 2
5|P a g e

6. MANAGERIAL ECONOMICS
TC = 420 + 60Q + Q 2
Marginal Costs (MC) = dTC/dQ
MC = 60 +2Q
Average Total Cost (ATC) = Total Cost/Q
ATC = (420 + 60Q + Q 2 )/Q
ATC = 420/Q + 60 + Q
Average Fixed Cost (AFC) = FC/Q
AFC = 420/Q
Average Variable Costs = VC/Q
AVC = (60Q + Q2 )/Q
AVC = 60 + Q
MARGINAL REVENUE
A curve that graphically represents the relation between the marginal revenue received by a
firm for selling its output and the quantity of output sold. A firm maximizes profit by
producing the quantity of output found at the intersection of the marginal revenue curve and
marginal cost curve. The marginal revenue curve for a firm with no market control is
horizontal. The marginal revenue curve for a firm with market control is negatively sloped
and lies below the average revenue curve. A marginal revenue curve is the graphical relation
between the marginal revenue a firm receives from production and the quantity of output
produced. The marginal revenue curve reflects the degree of market control held by a firm.
For a perfectly competitive firm with no market control, the marginal revenue curve is a
horizontal line. Because a perfectly competitive firm is a price taker and faces a horizontal
demand curve, its marginal revenue curve is also horizontal and coincides with its average
revenue (and demand) curve.
For firms with more market control, especially monopoly, the average revenue curve is
negatively-sloped. Because a firm with market control is a price maker and faces a
negatively-sloped demand curve, its marginal revenue curve is also negatively sloped and lies
below its average revenue (and demand) curve.
Perfect Competition-Perfect competition is a market structure with a large number of small
firms, each selling identical goods. Perfectly competitive firms have perfect knowledge and
perfect mobility into and out of the market. These conditions mean perfectly competitive
firms are price takers, they have no market control and receive the going market price for all
output sold.
6|P a g e

7. MANAGERIAL ECONOMICS
Marginal Revenue Curve,
Zucchini Style Marginal revenue is
commonly represented by
a marginal revenue curve, such as the one labeled MR and
displayed in the exhibit to the right. This particular marginal
revenue curve is that for zucchini sales by Phil the zucchini
grower, a presumed perfectly competitive firm.
The vertical axis measures marginal revenue and the horizontal axis measures the quantity of
output (pounds of zucchinis). Although quantity on this particular graph stops at 10 pounds of
zucchinis, the nature of perfect competition indicates it could easily go higher.
This curve indicates that if Phil sells the first pound of zucchinis (an increase in production
from 0 to 1), then his extra revenue is $4. However, if he sells his tenth pound (an increase in
production from 9 to 10), then he also receives $4 of extra revenue. Should he sell his
hundredth pound (an increase in production from 99 to 100), then he moves well beyond the
graph, but his marginal revenue remains at $4.Because Phil is a perfectly competitive firm,
his marginal revenue curve is also his demand curve and his average revenue curve. All three
curves coincide for perfect competition.
MARGINAL PRODUCT : A curve that graphically illustrates the relation between marginal
product and the quantity of the variable input, holding all other inputs fixed. This curve
indicates the incremental change in output at each level of a variable input. The marginal
product curve is one of three related curves used in the analysis of the short-run production of
a firm. The other two are total product curve and average product curve. The marginal
product curve plays in key role in the economic analysis of short-run production by a firm.
The marginal product curve illustrates how marginal product is related to a variable input. While the
standard analysis of short-run production relates marginal product to labor, a marginal product
curve can be constructed for any variable input.
The diagram to the right graphically represents the
relation between marginal product and the variable
input. This particular curve is derived from the
hourly production of Super Deluxe TexMex
Gargantuan Tacos (with sour cream and jalapeno
peppers) as Waldo's TexMex Taco World
restaurant employs additional workers. The number
of workers, measured on the horizontal axis, ranges
from 0 to 10 and the marginal Gargantuan Taco
production of each extra worker, measured on the
vertical axis, ranges from 0 to 30. Marginal Product Curve
The shape of this marginal product curve is worth
noting. For the first two workers of variable input, marginal product increases, as each added
worker contributes more to the total production of Gargantuan Tacos than previous workers.
This increasing marginal product is reflected in a positive slope of the marginal product
curve.Beyond the third worker, the marginal product declines, as each added worker
contributes less to the total production of Gargantuan Tacos than the previous worker. This
7|P a g e

8. MANAGERIAL ECONOMICS
decreasing marginal product is seen as a negative slope. The marginal product eventually
declines until it reaches zero and even becomes negative. This results as the marginal product
curve cuts through the horizontal axis.The hump-shape of the marginal product curve
embodies the essence of the analysis of short-run production. The upward-sloping portion of
the marginal product curve, up to the third worker, is due to increasing marginal returns.
Decreasing marginal returns sets in after the marginal product curve peaks with the second
worker and declines for the third worker. In particular, this declining segment of the marginal
product curve reflects the law of diminishing marginal returns.
Quiz 02 and 03 APPLYING MARGINAL ANALYSIS
Instead of applying a top down perspective on hotel departments and analyzing aggregate
figures, marginal analysis is about identifying the economic entities within the business and
comparing the value to the costs they generate. Obviously the former should be greater than
the latter. Marginalism is anything but rocket science. Rather, it is a mindset and requires the
willingness to examine every area of a business without taboos. How much incremental value
does an entity generate for the business? By how much would costs decrease if it was
discontinued? By how much would value increase if it was augmented? Often the analysis
comes down to comparing incremental revenues to the costs generated by the economic
entity. This is however not always the case, as the concept of value encompasses more than
revenues and includes such benefits as the enhancement of guest experience, increased team-
member motivation or improvement of the business‟ reputation. The fundamental principle
underlying marginal analysis is the explicit comparison of the incremental value versus
incremental cost generated by an economic entity. Let‟s look at some examples of entities
where marginalism can be useful. This list is far from exhaustive.
Operating days and hours of profit and service centers-The trading times of outlets
should be reviewed on a regular basis. What is the cost/benefit ratio of each operating hour?
The business hours of restaurants, bars, fitness clubs, etc … are often based on habits and
rarely questioned. In many hotels, outlet operating hours are the same for every day of the
week, despite potential regular variations in business patterns and guest demand among them.
Is the value generated by each hour of operation, especially at the beginning and the end of a
day, invariably higher than the costs? If the revenues generated do not cover the costs
incurred, is there another reason for maintaining the hours of operation? Such reasons may be
expectations by the hotel‟s guests. In any case, the value generated must outweigh the costs
and it must be stated explicitly. This analysis can also be extended to operating days. Hotels
with several food and beverage outlets often operate all of them seven days a week, although
some days may notoriously generate low revenues. Closing a bar or restaurant for a day per
week may boost outlet profitability, as all staff members take their off days simultaneously.
This substantially reduces required staffing to operate the outlet. Annual closings may also
have a positive impact on profit. Closing an outlet for a few weeks per year during a slow
season allows the scheduling of all annual staff vacations at the same time. This reduces the
team size required to run the outlet. Such decisions are not solely based on financials. Guest
expectations, quality criteria, etc … play an important role in finding the right solution.
Nonetheless it is critical, that the costs and value linked to such decisions are clearly spelled
out. The converse may also apply. An outlet may be opening too late or closing too early and
8|P a g e

9. MANAGERIAL ECONOMICS
thus miss valuable revenue opportunities. Extending operating hours may be beneficial and
marginal analysis helps in making the right decision.
Shifts and working hours-A similar challenge is posed by rota planning. Is the number of
shifts and the work-time schedule truly based on business requirements or once again driven
by habits? A daily productivity measurement tool with some clear productivity standards by
outlet and department will help monitor an operation‟s ability to correlate the scheduling of
resources with operational needs. Often, human resources and money are wasted because of
ineffective scheduling on slow days (i.e. week-ends) and slow periods (i.e. between meals or
early/late hours). This analysis is closely related to the previous one addressing operating
hours, as a change in shift planning may convert an unprofitable operating hour into a
profitable one. The exercise is easier for shifts in revenue generating positions such as
restaurant staff, as the cost of a shift or of working hours can be directly put against the
incremental revenue generated within the time period being analysed. However even for non-
revenue positions the cost of a scheduled time unit should be set against the value it
generates.
Profit centers-Do profit centers truly deserve their name or do they simply generate revenue
without profit margin? A food and beverage department yielding a low profit as per Uniform
System of Accounts for the Lodging Industry will often effectively make losses when all
relevant costs are attributed to it. Whilst the USALI allocates direct costs to their respective
departments, marginal analysis goes further and considers all costs directly generated by a
profit center, including opportunity cost. The fact that such analysis is complicated does not
diminish the importance of the exercise. Energy, credit card commissions, G&A resources,
etc … are considered undistributed operating expenses under USALI. They need however to
be included in marginal analysis in order to calculate the true profitability of a profit center.
While the cost of energy has often been neglected in the past, the increases of recent years
have made energy a critical cost factor. Opportunity cost refers to the foregone benefits of an
alternative operation. For example: Is the marginal value generated by an F&B outlet higher
than if the space was leased out or converted into meeting space? This question may be
relevant in hotels with several food and beverage outlets. Outside catering is also an area
worthy of detailed analysis. Hotels not specialized in this business often overestimate the
profitability of out-of-house catering. The P&Ls of events (when they are done at all)
frequently do not consider such items as the time spent on booking, planning and preparing
the event. They also overlook such costs as time spent on invoice preparation, account
collection, energy, credit card commission, increased loss and breakage of equipment, etc ….
Business processes-Marketing campaigns, training activities, F&B promotions etc … fall
under the category of business processes. Such economic entities are more difficult to analyze
in the context of marginalism as: 1) The value generated is often less tangible and difficult to
state in monetary terms; and 2) The value often comes with a time lag and sometimes over
several years, whereas the costs are incurred within a year. Despite these difficulties,
marginal analysis should still be applied. One major advantage of the exercise is that
objectives, costs and expected value creation have to be explicitly stated. In reality, a positive
net effect of such processes is often taken for granted without explicit attempt to define it.
While an F&B promotion can easily be analysed in terms of incremental costs versus
revenues generated, this is more complicated for image campaigns or training programmes.
But here also the value created has to be higher than the costs incurred, and it must be stated
with a clear time frame.
9|P a g e

10. MANAGERIAL ECONOMICS
Other uses of marginal analysis-Marginal analysis can also be applied to customer
segments or single accounts. Does a hotel maintain any transactions and contracts that are
unprofitable after accounting for all direct costs? Such costs pertain to distribution (GDS fees,
travel agent commissions, …), the variable cost of stay, revenue collection, opportunity cost
(displacement of alternative business), etc … The costs of distribution or channel costs can
shave off a good portion of the room rate and are often underestimated. An account with a
high room rate and high distribution costs may be less profitable than an account with a lower
rate and distribution cost. At the same time, third party channels frequently generate
incremental profitable business otherwise unavailable to a hotel, despite potentially high
distribution costs. On the other hand, is the hotel rejecting business which might be
detrimental to departmental profit percentages but would yield a positive profit margin? A
strong orientation towards departmental profit percentages increases this risk. From a purely
financial perspective and in the short-run, rooms must be sold at rates covering at least their
variable costs in order to generate a profit. Taking in groups at deeply discounted rates may
make financial sense in low demand periods, when servicing can be ensured through the base
staffing of a hotel. Once extra staff has to be scheduled (breakfast cooks & waiters, porters,
check-in staff) the low margins are often eroded by an increase in variable cost.
Reward Systems-Reward systems must be aligned with the ultimate objectives of the
company. This is important in the context of marginalism. Are Sales Managers for example
rewarded based on REVPAR or market share development, rather than GOPPAR? In such
cases, they will likely pay less attention to the profitability of business and rather focus on
room revenue maximization. Executive Chefs‟ bonuses are sometimes based on food cost
percentages instead of total F&B profit in Dollar terms. This encourages them to focus on
low food cost percentage rather than high dollar margin items. In addition, Chefs who have
menu pricing discretion may set prices at excessively high levels, harming the volume-
margin mix. This may be beneficial to the food cost percentage but negatively impact total
F&B profit in monetary terms.
Conclusion-Marginal analysis is a powerful tool to optimize the value creation ability of a
business. It is detail oriented and does not replace high level strategic planning. What‟s more,
the decisions made and the actions taken in marginal analysis must be compatible with the
overall, long-term strategy of the company. But within the context of a specific businesses
strategy, marginal analysis is useful to ensure that the operation is run as effectively as
possible. The costs and value generated by economic entities must be explicitly defined. In
reality this happens too rarely. When the value created is of non-monetary nature, the analysis
is more complicated but remains nonetheless critical. High-level average and aggregate
figures are useful for reporting and benchmarking purposes. For fine-tuning and action
planning however, marginal analysis is more powerful. It can be applied to all economic
entities within a business.
Operating Gearing and Marginal Analysis
If you have an activity, and it has high fixed costs compared to it‟s variable costs, then that
activity has high operating gearing.When operating gearing (OG) is high, a small change in
sales will have a much bigger effect on profit, so you can say that profits are more sensitive
to activity volume when OG is high.
10 | P a g e

11. MANAGERIAL ECONOMICS
Marginal analysis-If you need to make a decision that involves a limited time, and small changes to existing
practice, you mostly care about the variable costs. (Variable costs are the same thin g as marginal costs).
Variable costs change depending on the outcome of the decision, making them a relevant cost.
In the same vein, fixed costs are irrelevant because the decision won‟t affect them. Marginal analysis is what
you use to make short term decisions.
So what are some decisions marginal analysis might be used on? It‟s normally used in these four „key decision
areas‟:
Acception / rejection of special contracts
Determining the most efficient way to use limited resources
Decisions on making or buying something (aka outsourcing decisions)
Closing or continuation decisions
We‟ll go through each of the decision types in turn, with examples to explain.
Accepting / rejection of special contracts -If you remember the company that made llamas from the last post,
they have a spare capacity to make more llamas. A company overseas has offered to buy 300 llamas at £13 each
(normal selling price is £14). As before, the fixed costs are £500 and the variable cost per unit is £12. Should
they accept the offer?
There isn‟t really a right answer to this. By my calculations, they‟ll make 300 × £13 = £3,900 in revenue, and
the cost will be 300 × £12 = £3600. You don‟t need to include fixed costs, as they‟re being paid out regardless
of whether this decision is made.There are more factors than money to consider here though. Should they be
selling off the capacity for that price, or for more? What if other customers who have paid the higher price
complain? But the buyer is from overseas, maybe this purchase will help them enter a new market.So there isn‟t
a definite right answer here!
Determining the most efficient way to use limited resources -There‟s a company that makes 3 different
products: Chalk, cheese and benzoylmethylecgonine. Here‟s some more info about the products:
Machine time is limited to 148 hours / week. So what combination of products should be manufactured for the
highest profit?
So in this case, the machine time is the limited resource. The first thing to do is calculate how much profit each
product makes per unit. This is just revenue – variable costs, so gives us:
Chalk: £15
Cheese: £12
Benzoylmethylecgonine: £11
Now divide the profit by the machine time to work out how much profit each product makes in an hour of
machine time:
Chalk: £3.75
Cheese: £4
Benzoylmethylecgonine: £2.75
So now we have everything we need to solve the problem. Obviously we want to make as many units of cheese
as possible as it brings in the most profit, so let‟s have the machine make 20 units of cheese (to fill the weekly
demand, any more will be a waste of resources). As it has a machine time of 3 hours, making 20 units of cheese
will take up 60 of the machines 148 hours, leaving 88 hours.The next most profitable product is chalk, so we
want to make as much of that as we can. To fulfil the demand of 25 units would take 100 machine hours though,
11 | P a g e

12. MANAGERIAL ECONOMICS
so we can‟t completely fulfil the demand. Therefore we should just use all of the remaining 88 hours to make 22
units of chalk.
So the answer is:20 units of cheese and 22 units of chalk is the most profitable way of using the machine.
Decisions on making or buying something (outsourcing decisions)-Another example. A company needs to
acquire a chip for one of its products. They can subcontract the production of it, costing £35 p er chip, or produce
it themselves for total variable costs of £28 per unit.The problem is, the company doesn‟t have any spare
capacity, so they‟ll have to reduce the output of something else (call it product B) in order to make the new one.
Product B makes a contribution of £15.
What decision do they take?
Answer:What are the relevant costs here? It will cost £28 per unit, plus the £15 they „lose‟ from being unable to
make Product B. That gives a total of £43. Therefore they should subcontract it, as the co st to them is less.There
are a couple of other factors to consider though. Outsourcing means the company loses control over the quality
of it, and there could be problems with the supply down the line.
References
Internet
HNDM notes
K.N. Thushara samarasinghe
HNDM -15
12 | P a g e