Fixed and Variable Cost Control: Effective Cost-Cutting Strategies - Essay Example

Business Essay: Environmental Scan Business Essay: Environmental Scan The fictitious business under consideration for this paper is a plant assembling specific kind of auto parts from sourced raw materials through a semi automated process. The plant is privately owned by a partnership between Mr. Robert and Mr. Grey both of whom have a 50% share in the company and they bear equal losses or profit from the company. They also take a nominal amount from the business profits as their personal salaries. The business has been established for two years; it employees workers on a contract basis for the family and currently there are 100 workers employed at the rate of $70 per day, working 20 days a month. The two owners take care of the managerial aspects of the business, including financial forecasting; accounting and dealing with suppliers and buyers (there are no other salaried employees). Right now the business is facing great competition from rival manufacturers. As the operation is relatively small, producing only 6,000 units of output per month, they cannot enjoy economies of scale that are available to larger manufacturers, these manufacturers also have more clout over their suppliers (or have integrated backward operations) allowing for a lower cost of raw material which translates into lower prices for their customers. Similarly, challenging is the inflow of imported manufacturing parts from economies like China, Japan and Germany which can compete at prices lower than local prices. Government policies enhancing free trade and lowering of trade quotas means that without legislative protection, they have to introduce more efficient and effective ways of processing if the business is to remain afloat. The relative competitiveness in the market along with threat of new (more powerful) entrants will decide whether the business can continue to run or will have to be shut down. With the recession of 2008, the economy took a severe downturn and because of financial security concerns, the banks were reluctant to hand out loans to small businesses. The two partners started their business on self finance and in order to introduce new technology or managerial staff to run their business they will need more resources than they have on hand. Their focus for the past few months has been to form strong relationships with their current customers, including car dealerships, repair shops and the used car market, through strategic marketing and PR platforms. But at the moment they cannot gain customers in the car manufacturing sector as they don’t have the capacity to bring in large orders of the quality demanded by those. The major players all have private negotiations with the larger processing plants or they source them directly through imports. The current financial standing of the business is not enough to ensure profitability or expansion, modification strategies. Variable Cost per month- $ (100*70*20) + 2000 142,000 Average Variable Cost- $ 142,000/6000 23.67 Total revenue per month -$ 32*6000 192,000 The calculations indicate that the firm is not performing enough to generate a steady profit as the revenue is less than the total cost of producing. However, it would not be advisable for the firm to shut down operations as the loss being incurred now might well be less than the total fixed costs, which is what the firm would suffer if the management decides to shut down. The revenue per unit received is $32, according to economical rules a “in the short run, a firm will maximize profit or minimize by producing the output at which marginal revenue equals marginal cost (as long as producing is preferable to shutting down” (McConnel et al., 2008) The firm is producing output at the MC of $30, which is near enough to the marginal revenue of $32 and is following economically sound practices. From the calculation we can see that the Average variable cost is $23.67, which means that the MR of $32 covers the ATC as well as contributing $8.3 to covering up the fixed costs incurred in the process (Morrison, 1992). At the moment operations should be continued at the same level, unless the average variable cost increases. The total loss occurring at the moment can be calculated if the fixed costs are known. Implementing any new measures or strategies to improve the profitability of the firm will depend on whether a change in variable or fixed costs is possible or more feasible. The firm can either streamline its overhead costs so that each unit is produced more cheaply, increase prices if the external factors are favorable and the market will accept the change or change the basic function of their operation and restructure the firm to produce something more profitable in the long run. The major constraint is the financial capital required for restructuring or enhancing the production process by changing fixed costs like the plant and equipment. But it may be the most feasible solution for the company keeping in mind the competiveness of the market and the need to gain a competitive edge (Morrison, 1992; Khera, 2002). As the variable cost of workers is the greatest cost they incur in production, one possible venue is to bring greater automation in the plants along with implementation of softwares like ERP or specific manufacturing softwares to take over the manual jobs in the factory. While the process requires hiring experts as consultants (or creating a new position in the firm) along with the capital requirements for new hardware and software, in the long run the variable costs will go down and the increase in fixed costs will be offset by greater revenue and profits. Financial formulas can be applied to forecast the expected change in profit and cost structure; including interest expenses from the loans that will be taken or the bonds which will be floated to fund the project. Another way to generate liquid capital can be through making the firm public and floating shares in the market, but the current standing does not indicate that the response will be good and the owners are better off by taking liabilities and keeping control of their business in their hands. However, if the financial calculations do not show a viable solution by changing the structure of the processing and the external factors are against the firm it might make a compelling case to shut down operations for good. The moment the Marginal revenue goes low enough that even the average variable cost can no longer be covered, the firm will have a lower loss by shutting down operation than by continuing. References Khera, R. (2007). Fixed and Variable Cost Control: Effective Cost Cutting Strategies! Morebusiness.com. Retrieved from http://www.morebusiness.com/running_your_business/profitability/Controlling-Costs.brc McConnell, C. R., Brue, S. L., & Flynn, S. M. (2008). Economics. Principles, Problems, policies. 18th Edition, Chapter 9. The McGraw-Hill companies. Morrison, J. L. (1992). Environmental scanning. In M. A. Whitely, J. D. Porter, and R. H. Fenske (Eds.). A primer for new institutional researchers(pp. 86-99). Tallahassee, Florida: The Association for Institutional Research. Read More