Determination of the optimal level of production Essays

Determination of the optimal level of production Essays Determination of the optimal level of production Essay Determination of the optimal level of production Essay As we can see the determination of the break-even point provides valuable information to management. For instance, by comparing the targeted sales volume with the break-even point management can see the margin of safety of the firm. We have to remember that in the planning stage the forecasted sales revenue and costs are highly uncertain. Sales volume, for example, may drop due to an unforeseen competitors move. Costs may also be affected heavily by general increase in prices due to changes in governmental policy or other related factors.In view of the above management should also seek a sufficient margin of safety that provides reasonable assurance on the going concern of the firm in view of unanticipated changes. Economists extensively emphasize the determination of the optimal level of production. In this respect we will adopt the economist’s approach towards cost-volume profit analysis in determining the optimal level of production rather than the accountant’s approach. A break-even chart for an economist would appear as follows.The total cost and total revenue functions are non-linear. With respect to the total cost function the firm at low volumes of output experiences an increasing marginal cost2. Its effect however diminishes as output rises leading to a decreasing marginal cost. The reason behind the aforesaid effect of costs lies in the range of output covered by the economists approach. Unlike the accounting model, which has been utilised in the section 5. 1. 1, the economist’s model considers a wider range of output levels leading necessary the consideration of changes in factors of production efficiency.The effect on the form of the revenue function depends on the type of market structure the firm is operating in. Under the accounting model as shown in figure 5. 1 a straight line revenue function is the result of a firm operating under perfect competition3, thus being regarded as a price taker4. However, under the economists model in figure 5. 2 we considered imperfect market conditions whose revenue function is disturbed by marketing activities like promotion policies and competitive moves, leading to non-linear total revenue curve.The economic approach relies on the opportunity costs that comprise a normal rate of profit. This normal rate of profit is considered as the point that a firm is required to meet in order to continue operating. The normal rate of profit is shown as break-even point 1 in figure 5. 2. In view of the above, cost-volume profit analysis under the economist approach reveals the output level at which profit maximisation is achieved.At this output level the firm achieves the maximum short-run profits available in the market. Effective management should always try to reach the profit maximisation point in order to utilise the factors of production in the best way possible. In this respect cost-volume profit analysis also helps management to be effective in reaching the optimal activity level. Cost-volume profit analysis can also support management in the calculation of the most appropriate sales mix that leads to profit maximisation.Therefore it helps management to focus at the planning stage on the products that lead to the highest revenue. Let us further illustrate this point with the following hypothetical example: Let us assume that Auto Ltd. is engaged in the manufacturing of three types of cars, standard, off road and sport cars. The management of the company is analysing which are the most profitable products in order to focus their advertising and promotion activities on to meet or if possible even exceed the expected level of sales.The finance director of the firm stated that the business enterprise could afford to spend an additional ? 1,000,000 advertising expenditure during the year. This expenditure can be distributed on the products in accordance to the management discretion. For simplicity we will consider the effect of spending all this additional advertising costs on one product only. A useful tool that can be used in cost-volume profit computations is spreadsheets. Indeed an excel spreadsheet was used to calculate the cost-volume profit analysis both in units and in revenue.