Question

Cameron is the owner of a company that produces a mobile DJ system that allows party guests or bar patrons to stream from playlists that cue from their mobile devices. Given the revolutionary nature of the system, it took many failed trials to create a system that worked, at a total cost of $230,000 to develop. At this point, Cameron sells a unit for $6500, each of which costs $5000 in electronics components, materials, and labor to produce. He has a storage facility which cost him $1200 this month to rent. What costs should he take into consideration when deciding whether to fulfill a purchase order for an additional unit? Calculations and Explains

Answer 1

Note - TC(total cost) = TVC(total variable cost) + TFC(total fixed cost)

AVC(Average variable cost) = TVC/Q,

Q = output

MC(Marginal Cost) = TC(n)- TC(n-1) or dTC/dQ or dTVC/dQ, where d is the differential operator

Here,

Cost of development - 230,000 is known as sunk cost, as this cost has now been incurred and cannot be recovered, so it is sunk and hence should not play a role in business decisions

Storage Facility - 1,200 for monthly rent is Fixed Cost. Fixed cost doesn't vary with level of output and hence shouldn't inform business decisions as same fixed amount will be incurred irrespective of how much output is produced. It will not increase or decrease with change in output.

Cost of Raw material and labor- 5,000 is the variable cost.

Here, since variable cost is constant, average variable cost is equal to marginal cost, which is the cost of producing one additional unit of output. This cost should be taken into consideration while making business decisions.

Here, TVC = 5000Q, AVC = 5000 and MC = 5000

As long as price is greater than AVC, seller should fulfill the additional order.

Hence, here since 6500 > 5,000, seller must fulfill the additional order.

Hope the answer helped you :)