Exercises: Production costs and profit

Explain the difference between fixed costs and variable costs and write down how to calculate a firm's total cost. Give two examples of each type of cost in a café.

Classify these bakery costs as fixed or variable and justify each decision: shop rent, flour, the administrator's salary (the same payroll every month), yeast, and the wage of an assistant hired by the hour according to demand.

The figure shows the average cost (AC) and marginal cost (MC) curves of a firm, with their characteristic shape. The point where they intersect is marked with a question mark.

1. a) What does the marked point represent for the firm? Think about what happens to average cost at that level of production.
2. b) Reason why the marginal cost curve intersects the average cost curve precisely at its minimum, using the grade analogy: if your next mark is lower than your average, the average goes down.

A churro stall spends $\text{€}\ 60$ producing $100$ servings of churros.

1. a) Calculate the average cost per serving.
2. b) If preparing serving number $101$ costs it $\text{€}\ 0.40$, explain what that figure is (marginal cost) and how it differs from average cost.

A fruit shop takes in $\text{€}\ 3,000$ a month from sales and spends $\text{€}\ 2,200$ on stock, rent and wages.

1. a) Calculate its monthly profit and write down the formula you used.
2. b) Explain, with this example, the difference between revenue and profit.

Classify these gym costs as fixed or variable and justify each decision: the rent for the premises, the receptionist's fixed salary, the towels washed for each member who trains, the monthly fee for the management software and the drinks restocked in the vending machine.

A firm has fixed costs of $\text{€}\ 1,000$ a month.

1. a) Calculate the average fixed cost (fixed cost per unit) if it produces $100$ units and if it produces $500$.
2. b) Explain why fixed costs are said to "be spread thinner" as production increases.

Explain in your own words what a firm's break-even point is and why it is a figure every entrepreneur wants to know before opening. Use the example of a café that knows how many coffees it has to sell a day to avoid losing money.

A cake shop has fixed costs of $\text{€}\ 2,000$ per month and a variable cost of $\text{€}\ 4$ per cake.

1. a) Calculate the total cost and the average cost if it produces $500$ cakes per month.
2. b) Calculate the average cost if it produces $1,000$ cakes and explain why the average cost falls as production increases.

A T-shirt company has recorded its total costs: producing $0$ units costs $\text{€}\ 100$ (rent is paid regardless); $1$ unit, $\text{€}\ 140$; $2$ units, $\text{€}\ 170$; $3$ units, $\text{€}\ 210$; and $4$ units, $\text{€}\ 260$.

1. a) What is the firm's fixed cost? And what is the variable cost of producing $3$ units?
2. b) Calculate the marginal cost of the second, third and fourth units.
3. c) Calculate the average cost of producing $4$ units and explain how the marginal cost is evolving and why.

An ice cream shop sells $800$ ice creams per month at $\text{€}\ 3$ each. Its fixed costs are $\text{€}\ 1,000$ per month and each ice cream costs $\text{€}\ 1$ in ingredients and packaging.

1. a) Calculate the total revenue, total cost and profit for the month.
2. b) The owner is considering staying open for one more hour each day: in that hour she would sell $50$ ice creams, and the extra staff and electricity would cost $\text{€}\ 60$. Is it worth it for her? Reason your answer by comparing the revenue and cost of this decision.

An empanada bakery has fixed costs of $\text{€}\ 1,500$ a month and a variable cost of $\text{€}\ 3$ per empanada. It sells them for $\text{€}\ 8$ each.

1. a) Calculate the total cost and the profit for a month in which it sells $400$ empanadas.
2. b) Calculate the break-even point, $q^{*} = \frac{CF}{p - CVMe}$, and interpret the result.
3. c) Reason what would happen to the break-even point if the rent rose by $\text{€}\ 300$ a month.

A renovation company has fixed costs of $\text{€}\ 6,000$ a month. In a month with $4$ projects, its total costs were $\text{€}\ 26,000$.

1. a) Calculate the total variable cost and the average variable cost for that month.
2. b) Calculate the average cost per project.
3. c) The following month it expects $6$ projects with the same average variable cost: calculate the expected total cost and reason what will happen to the average cost.

A coach company has sold $30$ of the $40$ seats on a trip at $\text{€}\ 20$ each. A group of $5$ students asks for tickets at $\text{€}\ 12$; the additional cost of each passenger (extra fuel, insurance) is $\text{€}\ 6$.

1. a) Reason whether it is worth accepting the group by comparing the additional revenue and cost.
2. b) Explain why the company can charge different prices for the same trip without losing money, as long as the price exceeds a certain threshold.

A furniture company sells $200$ tables a month at $\text{€}\ 150$ each. Its fixed costs are $\text{€}\ 12,000$ a month and the variable cost is $\text{€}\ 80$ per table.

1. a) Calculate total revenue, total cost and monthly profit.
2. b) Calculate the average cost per table and the profit per table.
3. c) To sell $230$ tables it would have to lower the price to $\text{€}\ 140$: calculate whether this would be worth it.

A coffee roaster knows its total costs: producing $0$ kilos costs $\text{€}\ 500$ a month; $100$ kilos, $\text{€}\ 900$; $200$ kilos, $\text{€}\ 1,400$; $300$ kilos, $\text{€}\ 2,100$; and $400$ kilos, $\text{€}\ 3,000$.

1. a) State the fixed cost and the variable cost of producing $300$ kilos.
2. b) Calculate the average cost at each level of production.
3. c) Calculate the marginal cost of each $100$-kilo stretch and relate its evolution to that of the average cost: what happens to the average cost when the marginal cost is lower than it? And when it is higher?

The owner of a traditional bakery states: "If I invest in a continuous industrial kneading line, I will automatically reduce my unit costs and be able to sell much cheaper than the competition, securing the future of the business." Currently, he makes $1,000$ baguettes a day at an average cost of $\text{€}\ 0.80$ (with daily fixed costs of $\text{€}\ 500$ and a variable cost of $\text{€}\ 0.30$ per baguette). The new industrial technology would raise daily fixed costs to $\text{€}\ 1,400$, but it would reduce the variable cost to just $\text{€}\ 0.15$ per baguette. However, a market study estimates that maximum demand in his delivery area will not exceed $2,000$ baguettes per day at a price of $\text{€}\ 0.70$.

1. a) Numerically demonstrate whether the owner's statement is correct for his potential market: calculate the average cost per baguette with the new machinery if he produces and sells $2,000$ baguettes a day, and compare the daily economic profit of both options.
2. b) Calculate the exact daily production volume at which the industrial technology would become cheaper per unit than the traditional one (break-even point / point of indifference) and explain how this result relates to the minimum efficient scale.
3. c) Refute the owner's reasoning by analyzing two strategic risks or diseconomies of scale that threaten a small business that over-expands its technical capacity beyond the real size of its market.

The commercial director of a backpack factory proposes accepting an extraordinary order of $200$ units for a conference at a special price of $\text{€}\ 22$ per backpack. He presents the following argument to management: "Our average cost when manufacturing our usual output of $1,000$ backpacks is $\text{€}\ 18$, and we sell them in shops at $\text{€}\ 25$. Since they pay us $\text{€}\ 22$, we will make a clean $\text{€}\ 4$ per backpack above average cost, providing $\text{€}\ 800$ of additional net profit." However, the plant operates at the limit of its standard capacity: to manufacture those $200$ extra backpacks, overtime night shifts will be required, which will increase total variable costs from $\text{€}\ 12,000$ to $\text{€}\ 17,000$, while fixed costs remain at $\text{€}\ 6,000$.

1. a) Refute the commercial director's argument using precise calculations: determine the marginal cost per unit of the extraordinary order and calculate the real impact that accepting the offer would have on the firm's overall profit.
2. b) Explain the conceptual error made by the commercial director by making production decisions based on average cost instead of marginal cost.
3. c) Determine the minimum unit price at which the company could accept the order of the $200$ backpacks without reducing its prior profit, and state the marginalist rule for production optimisation.

The owner of an arepa food truck faces an especially difficult four-month winter season. His fixed costs are $\text{€}\ 3,000$ per month (vehicle lease, licences, and insurance, which must mandatorily be paid every month). For each arepa sold, he incurs $\text{€}\ 2.50$ in variable cost (ingredients and packaging), and the retail selling price is $\text{€}\ 6$. During the winter months, he expects to sell only $600$ arepas per month if he remains open at his usual location.

A novice consultant advises him: "Close down during the four winter months; since you are going to make losses, closing is the only way not to lose money." At the same time, a home delivery platform offers him the chance to operate from a ghost kitchen during that period: it guarantees sales of $1,000$ arepas per month at a reduced price of $\text{€}\ 5$, but the platform retains a $20\ \%$ commission on gross sales.

1. a) Evaluate the three options available for the four months (closing down completely, opening at the usual spot, or working with the platform): calculate the total accounting result for each alternative.
2. b) Use the shutdown rule criterion (short-run shutdown condition) to technically justify why the consultant's advice to close down to avoid losses is economically flawed compared to opening at the usual location.
3. c) Determine the minimum selling price that would mark the exact shutdown point for the food truck (below which it would indeed be advisable to suspend activity), calculate the monthly break-even sales volume to distinguish both concepts, and design an operational measure that would allow the business to lower said shutdown threshold.

A $20$-room rural hotel (maximum monthly capacity: $600$ room-nights) incurs fixed costs of $\text{€}\ 4,200$ per month and a variable cost of $\text{€}\ 12$ per occupied room each night (laundry, breakfast, utilities). Its standard rate is $\text{€}\ 50$ per night. In a low-season month, confirmed bookings from private guests are only $100$ room-nights.

A sports federation proposes booking an additional $120$ room-nights that month for a tournament, but offering a discounted rate of $\text{€}\ 25$ per night. The hotel's investment partner rejects the offer, arguing: "If we accept, our average cost per room sold will be over $\text{€}\ 31$; selling at $\text{€}\ 25$ would make us lose money on every room and worsen our accounts."

1. a) Refute the investment partner's analysis with data: calculate the hotel's monthly profit with and without the agreement with the federation, and show which cost measure he should have considered to make the correct decision.
2. b) Now assume that, to accommodate the entire federation ($120$ room-nights), the hotel had to cancel $30$ of the bookings from private guests who were paying the standard rate of $\text{€}\ 50$. Determine whether in this new scenario it would be advisable to accept the deal, quantifying the opportunity cost.
3. c) Design two conditions or clauses that the hotel should include in the negotiation with the federation to prevent regular customers from finding out about the discounted rate or demanding the same price (price discrimination without damaging brand image).

A textile cooperative must choose between two technologies to manufacture a new line of sustainable sweatshirts that it plans to sell on the market at a price of $\text{€}\ 25$ per garment:

• Artisanal technology (labour-intensive): fixed costs of $\text{€}\ 2,000$ per month and a variable cost of $\text{€}\ 15$ per garment.

• Industrial technology (automated): fixed costs of $\text{€}\ 8,000$ per month and a variable cost of $\text{€}\ 5$ per garment.

Analysts indicate that if the market responds favourably, demand will be $1,200$ garments per month; but if there is a slowdown in consumption, demand will fall to $400$ garments per month.

1. a) Calculate the break-even point for each technology and the indifference point between the two. Plot or reason which technology is more efficient depending on the level of activity.
2. b) Evaluate the monthly economic result of both technologies under the two demand scenarios ($1,200$ and $400$ units). Explain which technology exhibits higher operating leverage and how the proportion of fixed costs affects the volatility of profits in the face of changes in sales.
3. c) Formulate a justified strategic recommendation for the cooperative if the members show high risk aversion to financial bankruptcy and the probability of a slowdown is $50\ \%$.

A beach bar operates under a municipal concession. Its unavoidable annual fixed costs are $\text{€}\ 36,000$ (municipal fees, insurance, depreciation, and basic maintenance), which amounts to $\text{€}\ 3,000$ per month, whether it opens or stays closed. During the $7$ months of high season (April to October), the business generates total revenue of $\text{€}\ 140,000$ with cumulative variable costs of $\text{€}\ 63,000$.

For the $5$ months of low season (November to March), management is debating what to do. It has three options:

1. Close down completely: it generates neither revenue nor operating variable costs, but preparing and sealing the facilities costs $\text{€}\ 1,000$ in total.

2. Open only on weekends: it estimates generating $\text{€}\ 3,200$ per month with variable costs of $\text{€}\ 2,600$ per month.

3. Lease operations to a third party in winter: an event organiser offers to pay a total fixed rent of $\text{€}\ 2,000$ to use the premises for the $5$ months, with this operator assuming all variable and maintenance costs.

1. a) Calculate the consolidated economic result for the whole year under each of the three options and determine which one maximises the concessionaire's annual profit.
2. b) Technically justify the shutdown rule: why is it economically rational to maintain activity in winter under Option 2 even though monthly revenue ($\text{€}\ 3,200$) is lower than total monthly cost ($\text{€}\ 5,600$)?
3. c) Predict what would have to happen in the long run (when the municipal concession expires) for it to be worthwhile for the owner to renew the business, distinguishing the short-run decision logic from that of the long run.

Competition authorities are reviewing the acquisition of a logistics operator by a large e-commerce chain. Prior to the transaction, the company sold $10$ million items per year at an average cost of $\text{€}\ 14$ ($\text{€}\ 6$ of fixed costs and $\text{€}\ 8$ of variable costs). With the acquisition, the company doubles its capacity to $20$ million items per year: its overall fixed costs rise to $100$ million euros per year, but its variable costs drop to $\text{€}\ 3$ per item thanks to full automation.

Following the investment, the company sets its selling price at $\text{€}\ 7.50$ per unit across its entire catalogue. Its competitors, whose average cost is no lower than $\text{€}\ 11$, report that the large chain is engaging in predatory pricing to drive them out of the market and monopolise the sector.

1. a) Demonstrate quantitatively whether the firm enjoys economies of scale: calculate its unit average cost when operating at $100\ \%$ of its new capacity ($20$ million units) and when a drop in demand reduces its volume to $12$ million.
2. b) Evaluate the predatory pricing accusation: justify whether selling at $\text{€}\ 7.50$ constitutes selling below cost (internal dumping) under both output levels and analyse what incentives the firm will have regarding prices once the competition has shut down.
3. c) Draft a reasoned opinion as a Competition Commission analyst: should the transaction be approved unconditionally, prohibited, or made subject to specific remedies (for example, granting competitors access to the logistics network)? Argue your position by weighing productive efficiency gains against monopolisation risks.

A financial analyst with a net salary of $\text{€}\ 36,000$ per year decides to quit her job to found her own sustainability consultancy. To start the project, she contributes $\text{€}\ 40,000$ from her personal savings, which until then had been generating an annual return of $5\ \%$ in guaranteed investment funds. In addition, she uses commercial premises she owns as the company headquarters, which she previously rented out to an academy for $\text{€}\ 900$ per month.

At the close of her first year of activity, the company's accounts show the following data:

• Total revenue from consulting services provided: $\text{€}\ 105,000$.

• Explicit deductible expenses (utilities, software licenses, self-employment social security contributions, marketing, and an administrative assistant's salary): $\text{€}\ 58,000$.

A relative tells her: «The business has been an extraordinary success: you have made a clean $\text{€}\ 47,000$ in your first year, much more than you were earning in your old job».

1. a) Refute the relative's statement by calculating the accounting profit and the economic profit of the first year separately, accurately identifying and quantifying each of the implicit or opportunity costs.
2. b) Interpret the meaning of the economic profit obtained: determine whether the entrepreneur has created or destroyed economic value compared to her starting situation, and explain what rational decision she should make in the medium term if the figures remain unchanged.
3. c) Design a feasibility analysis: calculate the exact annual turnover the consultancy would need to reach to cover all its opportunity costs (zero economic profit or normal profit) and explain why in economics a zero economic profit is considered a satisfactory equilibrium situation.

Topic challenge. Is it viable to open an artisan bakery in your neighbourhood? Take on the role of an economic consultant and design a short-run feasibility study for this new business.

1. Obtaining real data: Look up the average hourly labour cost in the services sector on the CSO website and the average price per $kWh$ over the last week on the EirGrid website. Using these data and an estimate for ingredients, define the fixed costs ($CF$) of your premises and the variable costs ($CV$) per unit produced.

2. Production function and returns: Simulate adding $1$ to $5$ workers ($L$). Assign realistic Total Product ($PT$) values that reflect the law of diminishing returns, and calculate Average Product ($PMe = PT/L$) and Marginal Product ($PMg$).

3. Costs and results: Build a table showing $CT$, $CMe$, and $CMg$. Set a competitive unit selling price ($P$) and find Profit ($B = IT - CT$) for each employment level.

4. Final report: Write a reasoned one-page proposal recommending the optimal staffing level, justifying the technical and economic efficiency of your choice.

Assessment criteria:

• Accuracy in the mathematical calculation of productivities and cost structure.

• Thorough research and correct application of official statistical data (INE and REE).

• Analytical consistency in justifying the optimal production level and profit maximisation.