This exercise continues the topic from pages 435-437 (Assumption 1: fixed costs are fixed) of the textbook and provides two additional examples to help you appreciate how bulk discounts and productivity bonuses might affect the variable cost of materials and labour per unit of production.

Variable costs are not the same for all units of production

Example: Bulk discounts

What effect will bulk discounts have on the variable costs of a product? Bulk discounts arise in situations where customers are offered a discount if they buy more than a specified quantity of goods. Suppliers are happy to offer bulk discounts as this enables them to sell more goods. As goods are supplied in larger quantities suppliers save delivery costs and these savings are passed on to the customer through the bulk discount scheme.

A building supplies firm sells bricks at 30 pence each. On orders of more than 5,000 bricks, the building supplies firm offers a bulk discount of 10% on the total order. This means that each brick will cost 30 pence – (30 pence x 10%) = 27 pence. Thus the variable cost of bricks falls from 30 pence to 27 pence when a customer buys 5,000 bricks or more.

The same building supplies firm offers a 20% bulk discount on orders of more than 10,000 bricks. As a result of this discount, each brick will cost 30 pence – (30 pence x 20%) = 24 pence. Again, the variable cost of bricks falls from 30 pence when less than 5,000 are purchased to 24 pence when more than 10,000 bricks are bought in one go.

Will builders pass these discounts on to their customers? Or take the extra profit on large projects using a large number of bricks? In a highly competitive industry, bulk discounts will allow builders to offer keener prices on contracts to enable them to pick up more business.

Variable costs are not the same for all units of production

Example: Productivity bonuses

A fixings manufacturer offers the following productivity bonuses to employees:

• Hourly production of up to 1,000 units is paid at the standard labour rate of £10.00 per hour.
• Hourly production of 1,001 to 1,200 units is paid at the standard labour rate of £10.00 per hour + a productivity bonus of 5%
• Hourly production of 1,201 to 1,400 units is paid at the standard labour rate of £10.00 per hour + a productivity bonus of 10%
• Hourly production of 1,401 to 1,600 units is paid at the standard labour rate of £10.00 per hour + a productivity bonus of 15%
• Hourly production of 1,601 to 1,800 units is paid at the standard labour rate of £10.00 per hour + a productivity bonus of 20%
• Hourly production of 1,801 to 2,000 units is paid at the standard labour rate of £10.00 per hour + a productivity bonus of 25%

What effect will the above remuneration levels and productivity bonuses have on the direct labour cost of each fixing?

1,000 units of production in an hour represent a direct labour cost of 1p per fixing (1,000 pence (£10.00 = 1,000 pence) ÷ 1,000 units). At 2,000 units of production in an hour, each fixing will have a direct labour cost of ((£10 + £10 x 25%) ÷ 2,000) = 0.625 pence. However, at 1,801 units of production, the direct labour unit cost of each fixing will be ((£10 + £10 x 25%) ÷ 1,801) = 0.694 pence, while at a production level of 1,800 units each fixing will have a direct labour cost of ((£10 + £10 x 20%) ÷ 1,800) = 0.667 pence. On the other hand, production of only 200 fixings will give a direct labour cost per unit of 5 pence as production up to 1,000 units is paid at the rate of £10.00 per hour (1,000 pence (£10.00 = 1,000 pence) ÷ 200 units) whether one fixing or 1,000 are produced.

Thus, the way in which employee remuneration is structured and the presence of productivity bonuses will cause the direct labour cost per fixing to vary significantly over different levels of production.