Question

2. Scaling Up/KLEM

Consider the following cost structure to make umbrellas:

Capital                      10% (e.g., $1 per umbrella)
Labor                         20% (e.g,, $2 per umbrella)
Energy                      30% (e.g., $3 per umbrella)
Materials                 40% (e.g., $4 per umbrella)

1. (1 point) The production operation creates a second shift using the same plant. Labor, energy, and materials are all variable costs which go into an umbrella, whereas capital is a fixed cost (for the building, etc.) If the new operation has the same productivity as the old operation in terms of umbrellas per employee per shift, what is the new breakdown of cost percentages?

1. (1 point) If the new operation achieves double the labor productivity as the old operation (that is, not only are twice as many umbrellas made per day, twice as many are made per shift), what is the new cost breakdown?
2. (2 points) OK, so now we’re running two shifts. If half the energy required to make an umbrella is a direct marginal cost (for example, heating up the aluminum to make the interior struts) and half of it is a cost of operating the business (e.g., heating up the plant so the workers don’t freeze solid in the winter), how would moving to two shifts affect the cost structure? Hint: Start with your answer to (a) and think on a per-umbrella basis.
3. (2 points) These umbrellas don’t need to be made 100% by hand, however, and the company is considering an investment in automation so that many parts can be made by machine, with the final product simply assembled by hand (like Dell does). Starting off with the original 10/20/30/40 cost structure, if automation increases capital costs by one-quarter (that is, to 125% of their previous level) but reduces labor costs by half (that is, 50% of their previous level), how much will moving to automation reduce total cost on a percentage basis? (You may find Sutton’s Law to be useful here.)
4. (1 point) In a general sense, will investing in automation be more valuable to a factory that runs two shifts per day or one that runs only one shift? Why? (No calculation is required.)
5. (3 points) The new operation now both runs two shifts per day and automates the production. Including all the changes in capital, labor, and energy costs, how does the new total cost compare to original total cost? (You will find computing the new breakdown to be useful, but your answer should be in terms of percentage of original cost.)

Answer 1

b)

Capital	6.25%	$0.50	per umbrella
Labor	25.00%	$2	per umbrella
Energy	18.75%	$1.50	per umbrella	Initially energy needs for 200 umbrella would have been 200*3 = $600. Now half of it is cost of running business so $300 is spent for heating etc.Remaining $300 is for making umbrella. Hence per umbrella cost is $300/200 = $1.5
Materials	50.00%	$4	per umbrella

c)

Capital	13.51%	$1.25
Labor	10.81%	$1
Energy	32.43%	$3
Materials	43.24%	$4
Total	100%	$9.25
Percentage reduction in cost = ($10- $9.25)/$10
7.50%