Production Costs

Production does not have to be scheduled in NewShoes because your company manufactures its athletic shoes to meet demand. This simplification of reality means that you do not have to be concerned about inventory control if you over-produce, or about missed sales and employee overtime expenses if you do not schedule enough production. One of the major reasons the loss in Period 0 was not as great as in Period −1 was a lower manufacturing cost of the product. Cost per unit (a pair of athletic shoes) fell from $62.59 in Period −1 to $40.00 in Period 0 as production expanded from 102,000 units in Period –1 to 198,000 units in Period 0. Manufacturing expects cost of goods sold (COGS) to decline even further as the firm gains more experience with purchasing the component materials, making better use of equipment, and developing more efficient manufacturing processes. They estimate that the company is on a 75% learning curve, which means that costs are expected to fall 25%, to 75% of their previous level, each time cumulative production doubles.

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Table 1.B: Production Costs (previous 2 periods)

Home Units Domestic Units Total Units Unit Cost COGS

Period 0 67,600 130,400 198,000 $40.00 $7.9 million Period -1 102,000 NA 102,000 $62.59 $6.4 million

As your team takes over the company, cumulative production stands at 300,000 units. Based on manufacturing’s estimates, average unit cost should drop from the current $40.00 to $30.00 when cumulative production reaches 600,000 ($40.00 x 0.75 = $30.00), and drop further to $22.50 when cumulative production reaches 1.2 million units ($30.00 x 0.75 = $22.50). A graph of the Learning/Experience Curve for manufacturing is provided in Figure 1.A as a visual representation of how costs are projected to decrease with future increases in cumulative production.

Figure 1.A: Learning / Experience Curve

The current unit cost of the product is clearly an important factor in your pricing decision. But the experience effects on cost make it clear that you should not only consider current cost, but also the projected cost as sales expand. While setting a high price may seem to be the best way to maximize profitability, a lower price could increase sales enough to lower unit costs and make the company more profitable in the long run. In fact, because production costs are shared across all channels, it may be profitable simply to break even when pursuing sales in a new market if the increase in sales reduces unit costs for all markets.

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Unit cost is especially important when deciding on a price if you choose to bid on a contract. Winning a contract bid can have a positive effect on the profitability of your regular business in the market regions by increasing cumulative production and reducing product unit cost for all sales. Your total cost of goods may be lower with the contract than without it as the contract bid units move you to lower costs on the experience curve.