Homework 1 – Profits and Scale Economies
1. Suppose that last month, XYZ Corporation sold 1,000 widgets for $1.50 per
unit. Moreover, its costs were:
Inputs $300 Variable
Distribution $300 Variable
Overhead $500 Fixed
Depreciation/Amortization $100 Fixed
a. Adapting these costs using the basic cost function (C(q) = cq+F for q units
sold), determine the parameters c and F and the cost function C(q) for last
month for XYZ.
c = (300+300)/1000 = .6
F=500+100=600
Thus, the cost function is C(q) = .6q+600.
b. For last month, determine:
1. XYZ’s total profit.
Revenue is 1.5*1,000 = 1,500. Costs are 300+300+500+100 = 1,200.
Thus profits are 1,500-1,200=300.
2. XYZ’s unit cost.
Unit cost is C(q)/q, which is (.6q+600)/q = .6+(600/q). For q=1,000,
unit cost is .6+(600/1000)=1.2.
3. XYZ’s gross profit margin, both in per unit and percentage terms.
Per unit: Mg = P-c = 1.5 - .6 = .9
Percentage: %Mg = 100((1.5-.6)/1.5)% = 60%
4. XYZ’s EBIT profit margin, both in per unit and percentage terms.
This accounts for all fixed components.
Per unit: Mebit = P-c-(F/q) = 1.5 - 1.2 = .3
Percentage: %Mebit = 100((1.5-1.2)/1.5)% = 20%
5. XYZ’s EBITDA profit margin, both in per unit and percentage
terms.
This omits Depreciation/Amortization from F
Per unit: Mebitda = 1.5 - 1.1 = .4
Percentage: %Mebitda = 100((1.5-1.1)/1.5)% = 26.67%
c. Assuming the cost parameters and price are unchanged for this month,
suppose XYZ is able to sell 1,500 units instead of 1,000. Determine:
1. XYZ’s total profit.
Revenue is 1.5*1,500 = 2,250. Costs are C(1500) = .6(1500)+600 =
1,500. Thus profits are 2,250-1,500=750.
2. XYZ’s unit cost.
Unit cost is C(q)/q, which is (.6q+600)/q = .6+(600/q). For q=1,500,
unit cost is .6+(600/1500)=1.
3. XYZ’s gross profit margin, both in per unit and percentage terms.
Gross profit margin is unchanged.
4. XYZ’s EBIT profit margin, both in per unit and percentage terms.
This accounts for all fixed components.
Per unit: Mebit = P-c-(F/q) = 1.5 - 1 = .5
Percentage: %Mebit = 100((1.5-1)/1.5)% = 33.33%
5. XYZ’s EBITDA profit margin, both in per unit and percentage
terms.
This omits Depreciation/Amortization from F
Per unit: Mebitda = P – c – (500/q) = 1.5 - .6 – (500/1500)
= 1.5-.6-.3333 = .5667
Percentage: %Mebitda = 100((.5667)/1.5)% = 37.78%
d. Suppose that a personnel change that increases overhead to $600/month
would lower the marginal distribution cost by one-sixth. How many units
would XYZ need to sell in one month to have:
1. Lower unit cost.
The marginal distribution cost last year was 300/1000 = .3.
Reducing it by one-sixth would decrease it to .25. Then c would
fall from .6 to .55, while F would rise to 700.
Unit cost is then lower if .55+(700/q) < .6 + (600/q). This holds if
q>2,000.
2. Higher total profit.
The answer is the same, q>2,000. Intuitively, average revenue
(price) is the same for all q. Profit is q times the unit cost. Thus,
profit is higher whenever unit cost is lower.
2. The small California-based winery Sandlands Vineyards produces a
premium wine called Carignane. You have been hired as a consultant to
help Sandlands optimize.
a. Your first assignment is to summarize characteristics of last
year’s production. Data suggest that in the previous year,
Sandlands produced 1200 12-bottle cases. Its marginal cost
(per case) was constant at $167, and its average fixed cost per
case was $56. Assuming that costs are unchanged for this
year, determine a total cost function for Sandlands (i.e., total
cost as a function of number of cases made), using the
“basic” cost function structure.
c = 167, F = 1200*56 = 67,200.
Thus C(q) = 167q+67,200.
b. You also learn that despite having the capacity to produce
1500 cases of Carignane, Sandlands’ initial plan is to produce
the same amount as last year, 1200 12-bottle cases. As a
benchmark, assume that Sandlands will be able to sell 1200
cases at last year’s price of $26 per bottle. Calculate its total
revenue, total costs, and profit.
Revenue = 26 X 12 X 1200 = 374,400
Cost = 1200*(56+167) = 267,600
Thus Profit = 374,400 – 267,600 = 106,800
c. Suppose that Sandlands sells approximately 10% of its cases
of Carignane through Revel Wine, a distributor positioned to
serve a “new generation of winemakers.” Suppose you are
shown some data indicating that Sandlands earns an
operating profit margin (which incorporates all costs
mentioned above) of 24% per case on its sales to Revel. The
executive that showed you the data proclaims “look how
profitable we are selling through Revel… I’ve been telling
everyone we need to sell more through them.” Evaluate
whether this executive’s strategic suggestion is sound. Be
precise.
The overall operating margin is 100*(profit/revenue)%,
which is 100*(106,800/374,400)% = 28.5%.
Thus, operating profits from selling to Revel, at 24% of
revenue, are lower than the average. The executive is
wrong.