You own a firm with a single new product that is about to be introduced to the p

Question

You own a firm with a single new product that is about to be introduced to the public for the first time. Your marketing analysis suggests that the demand for this product could be anywhere between 500,000 units and 5,000,000 units. Given such a wide range, discuss the safest cost structure alternative for your firm. You are involved in the planning process for a firm that is expected to have a large increase in sales for the next year. Which type of firm would benefit the most from that sales increase: a firm with low fixed costs and high variable costs or a firm with high fixed costs and low variable costs?

Show how you arrived at the answer.

Explanation / Answer

Firm that would benefit the most from that sales increase is a one with high fixed costs and low variable costs. We got to the answer on two points:

1. The fixed cost remain fixed and constant whereas the low variable cost provide us higher contribution which ultimately increases the gains.

2. Observe the example:

Case 1 : High Variable cost = (100 - 80) 200 units - 1000 FC = +3000

and on doubling the sales, = (100 - 80) 400 units - 1000 FC = +7000

Case 2 : High Fixed cost = (100 - 20) 200 units - 10000 FC = +6000

and on doubling the sales, = (100 - 20) 400 units - 10000 FC = +22000

So, High Fixed Cost and Low Variable Cost is preferred.

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