This discussion is about the importance of costs. We have different definitions

Question

This discussion is about the importance of costs. We have different definitions of cost and they are very important in managerial decisions. You can not run a business successfully without having a clear picture of your cost structure. This will be a very simple case of understanding different definitions of costs, when you need them and why they are important in making decisions. You have been running a restaurant that serves lunch only and had a loss of $30,000 for the first year. When you received the financials, you gathered your executive team to make a decision whether you will continue your business or not. The members of your team had different opinions. Here is what they suggested: Team Member 1: Our total cost is greater than our total revenue for the first year. This is not sustainable. We should sell all the assets and close the restaurant. Team Member 2: You are right, our total cost is greater than our total revenue but this does not mean that it will be the same next year. Please keep in mind that we had an initial spending of $25,000 to renovate the restaurant and purchase utensils. This brings down our operational loss to $5,000 only. It is very close to break even. We should continue one more year to test it. Team Member 1: But it is still a loss of $5,000. We are not making money. Team Member 3: I don't understand how this can be possible. I calculated the cost of ingredients of a meal including the water bill and electricity usage and costs of all other variables directly related to meal and it comes out to be only $7 per meal. We are charging each customer $10. How can we have a loss? Team Member 1: This is a miscalculation. Are you adding the cost of the cook and the maid who serves the meal to customers? Team Member 3: I do not. Why would I? It is not part of the cost of a meal. You are paying for them anyways whether you cook or not. We only have one cook and one maid and they are here all day regardless of we serve our customers or not. They should not be a part of the cost of a meal. Even when I add their cost it makes $9 per meal. We should still be making money. Team Member 2: Is there any other cost that we have? How about rent? Do you add it? Team Member 1:The only remaining cost is rent. Team Member 2: How about rent? Do you add it? Team Member 3: No, we are paying the rent anyways too. I did not add it. If I add the rent, cost per meal becomes $11. Team Member 1: There you go! This is why we are losing money. We cant make money here. Team Member 4: Hold on! I just met with the Cook and asked him what will be the cost of a meal If I order one right now. He told me that the cost of one meal is just $5. We are charging $10 per meal, this should be profitable. How did you come up with $7 per meal? Team Member 3: I looked at total cost of all ingredients specific to meals and divided that by total number customers. On the average, we are spending $7 per customer. It is not $5. I wonder where this difference comes from. Assume the numbers in this conversation are all correct. 1-) Discuss how Total cost, Total variable cost, Total fixed cost, average variable cost, average fixed cost, marginal cost are used in this conversation. You can give specific references to the conversation. 2-) Based on the conversation, what would be your strategy? Please be specific in terms of your strategy. Do not only suggest to stay open or close the business. Explain why using numbers. ( I want you to focus on the cost side of business, therefore please do not make suggestions such as we need to increase or decrease the price of a meal. That is the demand side of it and we will discuss it later)

Explanation / Answer

Total cost is the sum of fixed costs and variable costs. here in this conversation the total cost includes rent, salary and meal ingredient costs.

Total variable cost includes the meal ingredient costs

Total fixed costs includes salary of cook and the rent paid for the restraunt/

Average variable cost is the sum of variable costs i.e cost of ingredients of meal divided by number of customers which is deemed to be $7 per meal .

Average fixed cost is sum total of fixed cost which is rent and salary here fivided by number of customers. this cost was ignored initially whole calculating the cost per meal.

Marginal cost is the additional cost in producing one more unit of meal.

when it comes to increasing profit we should try to reduce cost rather than increasing price.

Fixed costs like rent and salary tp cook and maid are unavoidable and cannot be reduced , the cost left is variable cost which includes the ingridient costs . The only way to inclrease profit is to reduce the variable costs by buyin the items in bulk and reducing the transportation cost of trips taken to get the material.

If the total cost is coming as 11$ per meal

11= $7 variable cost+$4 fixed cost

Out of $7 variable cost we can try to reduce it by 2-3$ by reducing the cost of ingredients by proper utilization.

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