Unit Cost

And finance Allah Shmoop How can unit fixed costs mislead

the misled Okay so you're in the wireless vibrating headset

business This year you spent a small fortune building all

the assembly and tuning elements you needed to crank out

tons of those headsets Well the initial cost was big

and the factory requires angle maintenance insurance and other costs

of about twenty five million bucks a year The factory

can handle production of up to a million units with

employees working nine hour days with loaded fully allocated costs

Buzz brain ink could produce these units for fifty dollars

each and wholesale them to places like Costco and Walgreens

and Wal Mart for one hundred dollars and well make

a nice living Things were generally running at capacity when

an order came in from China Yes it seemed like

almost the whole country wanted these things A one time

special order for a million units Special price Forty five

dollars each So this is a problem How can you

sell a product for less than it costs you to

make that product right Like here it cost you fifty

bucks and they want to buy him for forty five

so you can't You can't lose money on every sale

and I hope to make it up involving him or

something It doesn't work that way Well at least not

unless you live in either idiot ville or bankruptcy corner

So you reject that huge order from China that would

have lost you a whole bunch of money But then

some widely manager who actually bothered to pay attention to

this video said Hey wait a minute Does it really

cost us fifty bucks a unit to make these things

We have twenty five dollars of hard raw material costs

but then we kind of arbitrarily allocated twenty five dollars

toe Amor ties the factory's twenty five million dollars a

year costs on the current full capacity of a million

units a year we currently produce After all we've run

the factory only nine hours a day Well everyone in

the meeting becomes silent All the suits realized that the

allocation and twenty five dollars per unit is way too

high If the factory was going to crank out say

two million units instead of just one well then all

the numbers would change That is for the additional cost

of five bucks a unit The factory could pay time

and a half two employees running a midnight to nine

a M shift and that would add just five million

dollars total to the annual cost time and a half

would be sought after by a lot of workers They

make twenty bucks an hour is normal time so they'd

make thirty bucks an hour for working the overnight shift

No problem filling those jobs in the factory quickly Meanwhile

making a second million units could lead to other good

things that make that twenty five dollar allocation seem even

further off the mark like being ableto ordered double the

raw materials and have much more power with their vendor

suppliers That is they'd probably get even more volume discounting

than they already did under just one million units worth

of stuff right volume purchasing If they're hard materials plastic

and wires and bent metal things in the vibrating unit

thing in the battery holder couldn't they get ten twenty

thirty percent less if they were doubling the size of

their order Yeah probably so that riel allocation of twenty

five dollars have cost is now squishy and suspect and

almost a company murderer Well the order from China is

a one time thing Is it fair to lumpy in

that one time deal with the normal operations of the

business Could you argue that well operationally it makes sense

to keep the allocations as they are I keep the

twenty five dollars a unit allocation for that factory maintenance

costs for the first million and then on the extra

cost of human labor Well just add that extra five

bucks a unit to the raw material costs of twenty

five bucks a unit to get a total marginal cost

of thirty dollars a unit for each one sold to

China for forty five dollars Right you making fifteen dollars

If you think about the accounting that way is it

fair to break them up like that Since China's orders

well probably will never happen again Maybe not the worst

idea to break them out separately anyway Think of it

this way You're starting a quote New unquote business for

the China Order Your regular operations represent the old business

The new businesses selling one year's worth of production in

China at nice profit margins fifteen dollars a unit You're

having toe higher up To do so you're having to

readjust union contracts and other things to accommodate for that

one year period If you just blended everything together for

a company wide two million units sold well then it

would kind of cloud the rial inputs and the rial

margins and the rial direct costs here So if you

think about things you almost rejected China's offer ordeal thinking

that you'd be losing five dollars a unit in doing

so But because someone on your staff watch this video

you wisely accept that offer and make fifteen dollars a

unit times a million And that's fifteen million box extra

for your company money you'd have otherwise rejected It's totally

fine If you want to send shmoop a percentage of

your gains here you know we do take gratuities You're

welcome