Assume You Have Been Hired As A Managing Consultant By A Com
Assume You Have Been Hired As A Managing Consultant By A Company To
Assume you have been hired as a managing consultant by a company to offer some advice that will help it make a decision as to whether it should shut down completely or continue its operations. It currently employs 100 workers to produce 6,000 units of output per month, working 20 days per month. The daily wage per worker is $70, and the price of the firm's output is $32. The cost of other variable inputs amounts to $2,000 per day. The firm’s fixed costs are sufficiently high so that total costs exceed total revenue. The marginal cost of the last unit is $30.
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The decision for a firm to continue or cease its operations hinges on a careful analysis of its cost structures, revenue streams, and profit outcomes in the context of its current market environment. The fundamental economic principle guiding this decision is whether the firm's marginal revenue exceeds or equals its marginal cost in the short run, and whether it can cover its variable costs. When total costs surpass total revenue, the firm faces a precarious financial situation, but an in-depth analysis is essential to determine if shutting down or continuing operations is the rational choice.
Understanding the Firm's Current Financial Position
The firm employs 100 workers, with daily wages of $70 each, working 20 days per month. This leads to daily wage costs of:
\[
100 \text{ workers} \times \$70 = \$7,000 \text{ per day}
\]
Given that total production is 6,000 units per month, spreading across 20 working days, the daily production volume is:
\[
\frac{6,000 \text{ units}}{20 \text{ days}} = 300 \text{ units/day}
\]
The firm's revenue per day based on the output price is:
\[
300 \text{ units} \times \$32 = \$9,600
\]
Variable costs include wages and other variable inputs totaling:
\[
\text{Wages} + \text{Other variable inputs} = \$7,000 + \$2,000 = \$9,000 \text{ per day}
\]
Therefore, the firm's daily contribution margin (revenue minus variable costs) is:
\[
\$9,600 - \$9,000 = \$600
\]
This indicates that, on a daily basis, the firm is earning a contribution toward fixed costs, but not necessarily covering all fixed costs, which are high enough that total costs exceed total revenue, as given.
Cost and Revenue Considerations
The average variable cost (AVC) per unit is:
\[
\frac{\text{Total variable costs per day}}{\text{Units produced per day}} = \frac{\$9,000}{300} = \$30
\]
The marginal cost (MC) is given as \$30, which aligns with the AVC per unit, suggesting the firm produces at a cost that meets the marginal cost for the last unit.
The revenue per unit (price) is \$32, which exceeds the MC of \$30, implying that producing additional units would contribute positively to covering fixed costs. However, since fixed costs already cause total costs to surpass total revenue, the firm's operating loss in the current state inevitably persists.
Short-Run Decision Analysis
In the short run, a firm should continue operations if it can cover its variable costs and contribute something toward fixed costs. The economic principle follows that if the price (or marginal revenue) exceeds the average variable cost, the firm should operate in the short run, even if it incurs a loss overall, because shutting down would mean losing contribution margins entirely and still bearing fixed costs.
In this case:
\[
\text{Price} = \$32
\]
\[
\text{AVC} = \$30
\]
Since \( P > AVC \), the firm should, in theory, continue operating in the short term because it can cover all variable costs and contribute \$2 per unit towards fixed costs.
Implications of Fixed Costs and Total Costs
However, the reality is that fixed costs are high enough so that total costs exceed total revenue, resulting in an overall loss. Yet, continuing operations may prevent the firm from incurring higher losses associated with shutting down, especially if some fixed costs are unavoidable or sunk. Shutting down would mean losing all contribution margins, which may worsen the financial position if fixed costs are unavoidable in the short term.
The Decision: Continue or Shut Down?
Given the information, the firm should continue operating in the short run because it is covering variable costs and making a positive contribution per unit. This will help reduce overall losses compared to shutdown, where total loss would equal total fixed costs, which are already high.
However, in the long run, if fixed costs remain high and fixed costs continue to outweigh revenues despite positive marginal contributions, the firm will need to reevaluate its viability, potentially restructuring or discontinuing operations.
Strategic Recommendations
1. Cost Management: The firm should analyze its fixed costs to identify opportunities to reduce fixed expenses, which are the primary drivers of losses.
2. Pricing Strategies: If feasible, the firm could explore increasing prices—though market conditions and competitive positioning could limit this.
3. Output Expansion: Since the marginal cost is below the price, expanding output could improve margins if demand allows.
4. Market Analysis: The firm needs to reassess its market position and demand elasticity to ensure sustained profitability.
5. Long-term Viability: Consider product diversification or operational restructuring to lower fixed costs or increase prices.
Conclusion
In the short run, the firm should continue operating because it covers its variable costs and contributes toward fixed costs, despite the overall loss. Persistent high fixed costs, however, threaten long-term sustainability, which necessitates strategic actions such as cost reductions or market adjustments. Ultimately, unless the firm can reduce fixed costs or improve revenue, shutting down may become inevitable in the long-term perspective.
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