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Average Cost versus Marginal Cost

Suppose the Blume Corporation has a variable cost per pencil of 55 cents. The lease payment on the production facility runs \$5,000 per month. If Blume produces 100,000 pencils per year, what are the total costs of production? What is the average cost per pencil?

The fixed costs are \$5,000 per month, or \$60,000 per year. The variable cost is \$.55 per pencil. So the total cost for the year, assuming that Blume produces 100,000 pencils, is:

60,000

The average cost per pencil is \$115,000/100,000 = \$1.15.

Now suppose that Blume has received a special, one-shot order for 5,000 pencils. Blume has sufficient capacity to manufacture the 5,000 pencils on top of the 100,000 already produced, so no additional fixed costs will be incurred. Also, there will be no effect on existing orders. If Blume can get 75 cents per pencil for this order, should the order be accepted?

What this boils down to is a very simple proposition. It costs 55 cents to make another pencil. Anything Blume can get for this pencil in excess of the 55-cent incremental cost contributes in a positive way towards covering fixed costs. The 75-cent marginal, or incremental, revenue exceeds the 55-cent marginal cost, so Blume should take the order.

The fixed cost of \$60,000 is not relevant to this decision because it is effectively sunk, at least for the current period. In the same way, the fact that the average cost is \$1.15 is irrelevant

marginal, or incremental, revenue

The change in revenue that occurs when there is a small change in output.

Ross et al.: Fundamentals I IV. Capital Budgeting I 11. Project Analysis and I I © The McGraw-Hill of Corporate Finance, Sixth Evaluation Companies, 2002

Edition, Alternate Edition

360 PART FOUR Capital Budgeting because this average reflects the fixed cost. As long as producing the extra 5,000 pencils truly does not cost anything beyond the 55 cents per pencil, then Blume should accept anything over that 55 cents.

accounting break-even

The sales level that results in zero project net income.

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