In the aftermath of a hurricane, an entrepreneur took a one-month leave of absen
ID: 1252754 • Letter: I
Question
In the aftermath of a hurricane, an entrepreneur took a one-month leave of absence(with out pay) from her $4000 per month job in order to operate a kiosk that sold fresh drinking water. During the month she operated this venture the entrepreneur paid the government $2000 in kiosk rent and purchased water from a local wholesaler at a price of $1.23 per gallon.Write an equation that summarizes the cost function for her operation, as well as equations that summarize the marginal, average variable, average fixed, and average total costs of selling fresh drinking water at the kiosk.
If consumers were willing to pay $2.00 to purchase each gallon of fresh drinking water, how many units did she have to sell in order to turn a profit? Explain carefully.
Explanation / Answer
The trick on this question is opportunity cost. In every decision there are direct and indirect costs. There is also a cost of simply taking the action. For example, money needed to fund the business could stay in the bank earning interest. In this instance the interest earned is the opportunity cost. It will be a wise decision if and only if the action results in more income than if the money was in the bank. Reflecting this reality, many businesses require that new opportunities generate a minimum rate of return which usually is the interest rate the company earns plus the businesses profit goal (say 10%) and often some additional premium to reflect the risk in this project. The sum of interest rates + profit goal + risk premium is often referred to as the hurdle rate. However, only the interest lost is opportunity cost.
If the water kiosk was the best thing the entrepreneur could do the only fixed cost would be rent. However, the entrepreneur gave up $4000 in salary and that represents the opportunity cost.
marginal cost = cost of the water + (fixed costs/gallons sold)
marginal revenue = $2.00 per gallon
contribution margin = marginal revenue - average variable cost
average variable cost = cost of the water
average fixed cost == rent + salary lost
average total cost = (rent + salary lost) + (the number of gallons purchased multiplied by the cost per gallon)
to find the number of units to reach break even, divide fixed cost (rent + salary lost) by the contribution margin.
to find the number of units to turn a profit add one unit to the number of units to reach break even.
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