Calculation of Estimated the Average Cost per Unit

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Sub: Finance                                                               Topic: Capital Budgeting

Calculation of Estimated the Average Cost per Unit

Question:

A soft drink company has three bottling plants throughout the country. Bottling occurs at the regional
level because of the high cost of transporting bottled soft drinks. The parent company supplies each
plant with the syrup. The bottling plants combine the syrup with carbonated soda to make and bottle
the soft drinks. The bottled soft drinks are then sent to regional grocery stores.

The bottling plants are treated as costs centers. The managers of the bottling plants are evaluated
based on minimizing the cost per soft drink bottled and delivered. Each bottling plant uses the same
equipment, but some produce more bottles of soft drinks because of different demand. The costs
and output for each bottling plant are:

A                     B                 C
Units Produced          \$10,000,000           20,000,000        30,000,000
Variable Costs          200,000               \$450,000          \$650,000
Fixed Costs             1,000,000             \$1,000,000        \$1,000,000
a) Estimate the average cost per unit for each plant.

b) Why would the manager of plant A be unhappy with using the average cost as the
performance measure?

c) What is an alternative performance measure that would make the manager of plant A
happier?

d) Under what circumstances might the average cost be a better performance measure?

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Sub: Finance                                                               Topic: Capital Budgeting

Solution:

A                B                C
Units Produced (a)                           10,000,000 20,000,000 30,000,000
Variable Costs (b)                           \$200,000         \$450,000         \$650,000
Fixed Costs (c)                              \$1,000,000 \$1,000,000 \$1,000,000

a)
Total cost of production (d = b + c)           \$1,200,000 \$1,450,000 \$1,650,000
Average cost per unit (e = d/a)                \$0.12            \$0.07            \$0.06

b) The plant A is having the highest average cost per unit of production. This is because the fixed cost
is also considered in the computation of cost of production. Each plant is having a different units of
production and the fixed cost are allocated based on the units produced. Since plant A is having the
lowest level of production, large amount of fixed cost is getting allocated to the cost of production.
This is making the manager of plant A unhappier.
c) Variable cost per unit should be used to measure the plant's performance. Fixed cost are
unavoidable cost and they are the same in each of the plants. So only variable cost should be
considered in performance measurement by computing the per unit variable cost of production.

d) Average cost is a better performance measure when the actual production is equal or more than
the expected production. This is due to the fact that the fixed cost is estimated based on the expected
production and is allocated based on the actual production. So if the actual production is higher than

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Description: "a) Estimate the average cost per unit for each plant. b) Why would the manager of plant A be unhappy with using the average cost as the performance measure? c) What is an alternative performance measure that would make the manager of plant A happier? d) Under what circumstances might the average cost be a better performance measure? "