Multiple Choice Questions
1. A manufacturing company is considering purchasing a new machine that doubles capacity from 500 to 1,000 units per week. The machine will occupy approximately 500 square feet of vacant (unused) space on the factory floor. Which of the following costs are irrelevant in the decision to purchase this machine?
a) The additional cost of utilities necessary to run the machine.
b) Monthly rental expense associated with the 10,000 square foot factory.
c) Additional machinists who will need to be hired to run the machine.
d) Maintenance costs for regular repair and cleaning of the machine.
2. A company manufactures both pens and pencils in the same facility. The firm’s production capacity is shared between these two products. Due to a federal ruling requiring all elementary school students to use only pencils, the overall demand for pencils has shifted outward. Surprisingly, this has had no effect on pen demand. The firm will find in the short term that:
a) the cost of producing pencils rises.
b) the cost of producing pens falls.
c) pencils are more profitable than pens.
d) the cost of producing pens rises.
3. In comparing a firm’s accounting costs with its economic costs, the accounting costs:
a) are the same, if the firm is earning a normal rate of return.
b) are larger.
c) take account of the implicit cost of owned resources.
d) are smaller.
4. The average capital invested in Firm X during the year is $20,000. During that same year, Firm X produces after-tax income of $3,200. If the firm’s cost of capital is 12%, what is the economic profit?
a) $0 b) $800 c) $1,200 d) $3,200
5. Which of the following costs always must be considered relevant in decision-making?
a) Variable costs b) Avoidable costs c) Fixed costs d) Sunk costs
Short Answer Questions
Production Opportunity Cost
A can manufacturing company produces and sells three different types of cans: versions X, Y, and Z. A high-level, simplified profit/loss statement for the company is provided here. Corporate overhead (rent, general and administrative expense, etc.) is allocated equally among the three product versions. After reviewing the statement, company managers are concerned about the loss on Version Z and are considering ceasing production of that version. Should they do so? Why or why not?
If one has a strict interpretation of “sunk costs”, then they should not pull the plug on producing can Z. This is because: Although the line of cans is losing money ($37,500 in the black), if one factors in the fixed overhead costs of $60,000, the can is actually profitable. Thus, since a producer should not take into account fixed costs, the production of can Z should continue.
Opportunity Cost of Renting
You currently pay $10,000 per year in rent to a landlord for a $100,000 house, which you are considering purchasing. You can qualify for a loan of $80,000 at 9% if you put $20,000 down on the house. To raise money for the down payment you would have to liquidate stock earning a 15% return. Neglect other concerns, like closing costs, capital gains, and tax consequences of owning, and determine whether it is better to rent or own.
There are two scenarios presented in this question: an individual who rents a house versus an individual who purchases a house.
- $10,000 annually spent in rent
- $80,000 loan at 9% if $20,000 is put down
- In order to do this one would have to liquidate a stock currently earning 15%
This problem turns on the opportunity cost lost in renting the property versus the opportunity cost lost in selling the stock in order to pay for the property: A decision to continue renting would allow one to keep the 15% returns on the stock (although this return cannot be extrapolated infinitely into the future) but without owning the property versus the upside of owning the house (and potential gains) versus the near-term loss of the stock and paying an additional 9% on the capital needed for the loan.
While this is a difficult decision, it would depend on your preferences to get into the property market versus continued capital gains on stock- traditionally, except for the time period since 2007 the housing market has seen decent appreciation. In addition, I do not expect the 15% return on the stock would last forever; thus, I would likely sell out to own the property and hope for an increase in the house’s value.
Opportunity Cost of Steel
Your firm usually uses about 200 to 300 tons of steel per year. Last year, you purchased 100 tons more steel than needed (at a price of $200 per ton). In the meantime, the price of steel jumped to $250 per ton delivered (which means that any firm selling the steel must pay any shipping costs), and the price has since stabilized at that price. The cost of shipping steel to the nearest buyer would be $20 per ton. In the meantime, a business next door just went bankrupt and the bank is offering a special deal where you can buy another 100 tons of steel for $180 per ton. Assume that the interest rate is 0%. Which of the following are correct?
a. Sell your 100 tons at the going market price of $250 and make a profit of $30 per ton ($50 less $20 cost of shipping).
b. Buy the 100 tons next door at $180 and resell at a price of $250 less $20 shipping, for a net profit of $50 per ton.
c. Hold onto your 100 tons and wait until it is needed for production.
d. Buy the 100 tons next door at $180 and hold onto it until it is needed in production.
Annual use: 200-300 tons: Additional 100 tons at $200 per ton $250- $220 per ton.
Answer B is correct.
The expression “3/10, net 45” means that the customers receive a 3 percent discount if they pay within 10 days; otherwise, they must pay in full within 45 days. What would the seller’s cost of capital have to be in order for the discount to be cost justified?
In order for the discount to be cost justified, the firm’s cost of capital would need to be less than the lost opportunity cost of the discount (3%).