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Variable vs Fixed CostsResearch Proposal

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Smitheford Ops Management

The author of this report has been asked to assess and otherwise analyze the manufacturing situation of Smitheford Pharmaceuticals. The company has enjoyed major expansion in the past but they have also had issues. All of this has culminated in a new drug that can make the company a lot of money but they have to upgrade their technology at least somewhat to do so. The author is asked to assess whether a lower technology option is the best way forward or if the higher technology option is the way to do. While the higher technology option has a better variable cost per unit, the fixed costs are a lot higher and thus there is a minimum level of production that will be required to justify going for the higher technology option.

Analysis

The author is first asked which option between the high and low technology options is the best at years 1, 5 and 10. Because the variable cost option is lower for the high-technology solution and because the fixed cost is higher, the answer is not completely clear. It is clear that sales volume predictions are identical irrespective of which option is chosen. The variable cost per unit differential is $2.58 per unit. This means that over the first year, the high-tech option would be more expensive, although not by a huge amount. The lost cost option costs $1,999,000 while the high-tech costs $2,251,000. In short, there is a little over a quarter million difference over year one. In both cases, the applicable formula is the annual fixed cost plus the product of the units (100,000 in this case) times the variable production cost. In year five, the low cost technology option would yield $3.321 million in costs. The high technology option would yield a cost of $3.392 million. This is still higher than the low-tech option but not by much. Indeed, the difference is about $71,000. In year ten, the high-tech would cost $4.289 million given the presumption of 225,000 units. The low-tech would cost $4.360 million. As such, the high-tech solution wins out in terms of overall costs somewhere between the five and ten-year marks but this presumes that sales volume progresses as is projected. The setbacks with Osto54 prove that it is not all that wise to assume that. Further, the margin between the two options is rather razor-thin given amount of time that is necessary for the high-tech option to win out.

The next question to be asked is how much the variable cost would have to be in year five to justify the additional fixed cost of the automated alternative. Basically, this can be found by taking the revenue of the low-cost option in year five, the same volume but plugging in x for the variable cost since that is what is being solved for. In other words, the formula to solve and its following steps would be as follows:

170,000x + 620,000 = 3,321,300 Revenue amount for year 5 low-tech under given numbers

170,000x = 2,701,300 -- Subtracted 620,000 from each side

X = $15.89 -- Divided both sides by 170,000

What the above means is that if the tipping point is lowering the cost of the high-tech cost option enough to match the low-tech option via means of lowering the variable cost, then the variable cost of the high tech option per unit would have to be no more than $15.89. If it were that much, the low-tech and high-tech options would be identical in terms of cost. This would mean lowering the cost per unit on the high-tech option by about forty-two cents per unit. Given that this is a 2.57% dip (0.42 / 16.31), that is not entirely unobtainable. However, the linchpin and catalyst for whether all this math works is whether the demand for the drug is there or not. The high-tech option would most certainly be the better long-term option but it would be another huge blow to Smitheford if there is another failure when to comes to drugs. If there are patient deaths or the drug otherwise has to be pulled off the market, the company will be in dire straits financially unless they have very deep pockets (Accord Clinical, 2016).

Basically, two things have to be assured before the author of this report would justify recommending the high-tech/centralized option over the low-tech/decentralized option. Even though the centralized option is indeed the best way to go in terms of being able to keep everything in one place. Indeed, Pueblo and Colorado Springs are very close together (both on the same stretch of highway in Colorado) and having to have Puerto Rico as a stopping point in between would be rather silly and risky if it can be avoided. However, one thing that has to be in place for this to make sense is the sales volume. If the sales volume is not as predicted, the numbers calculated above will not hold and Smitheford will have another big mess on its hands.

Smitheford also needs to be very sure that their new drug, that being Ulamyacin, will not cause the same or similar problems as Osto54 did. It has to be ensured that the drug is effective and does not affect important functions or parts of the body including enzymes, the liver in general, the heart, the lungs, the pancreas or the kidneys. All of those are parts of the body and its systems that can literally kill a patient if the effects of a drug are not figured out completely. Before pulling the trigger on the high-tech option, it has to be ensured that the drug is safe and that full FDA approval is tendered. Beyond that, internal measurements should find no sign of problems and those measurements should go very far beyond what the FDA and other regulatory agencies require. Of course, Osto54 had FDA approval if it was being sold and it is clear what happened after that. Smitheford will be on the hook if there are further problems, not the FDA.

Generally speaking, the centralized option is far superior to the decentralized option. Even if Pueblo and Colorado Springs were not that close together (and they are), having two close locations like that and Puerto Rico (which is in the Caribbean island chain in the same area as Cuba and Haiti, to name a few) is a lot of travel time and effort just to bring it back to a location that is just down the road. Due to the locations involved, the same could really be said for any other location in the United States, especially those anywhere other than southwest of Colorado, which would typically make the transit time even worse. Even so, the fixed costs are a lot higher with a centralized option and thus that issue needs to be dealt with (Boundless, 2016).

Another important factor to take into account is that the drug in question is probably under patent and this means there is some flexibility as to pricing since generics will not be allowed for quite a while. That being said, there can be stiff competition when it comes to drugs so having a higher price point will not be the wisest course unless Ultramyacin is clearly superior to the other options that treat the same disorder. For examples, if a new drug came out that could combat MRSA on a level that other drugs could not touch, then that drug could easily be sold for a higher price point. However, if the drug performed at roughly the same level, then that would not be the case (Mayo, 2016). Finally, it has to be realized that charging too much (even when one can do so) can raise the ire of regulators and politicians. However, since Smitheford developed this drug themselves, the ire will not be nearly as bad as it would be as compared to a company that bought the rights to the drug and then jacked up the price. Turing Pharmaceuticals is a good example of a firm that has caught holy Hell for doing that (Mullin, 2016).

Conclusion

In the end, Smitheford would probably be wise to use the high-tech option if they can get the variable cost and sales figures where they need to be. If either of those is not in line, they should use the low-tech option. Smitheford has been over-aggressive in the past and it has cost them. They need to avoid a repetition of that at all costs. They should also have the resources on hand to pay out court settlements, whether it be a cash pile or insurance, in case it happens again.

References

Accord Clinical. (2016). How are drugs tested - Accord Clinical Research. Retrieved 27

February 2016, from http://www.accordclinical.com/clinical-study/how-are-drugs-tested/

Boundless. (2015). Types of Costs. Boundless. Retrieved from https://www.boundless.com/economics/textbooks/1515/production-9/production-cost-

64/types-of-costs-240-12338/

Mayo. (2016). MRSA infection - Mayo Clinic. Mayoclinic.org. Retrieved 27 February 2016, from http://www.mayoclinic.org/diseases-conditions/mrsa/basics/definition/con-20024479

Mullin, E. (2016). Turing Pharma Says Daraprim Availability Will Be Unaffected… [END OF PREVIEW]

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