Investment Decision Based on Market Demand
You're evaluating whether to purchase a toy-manufacturing machine that costs Rs. 10 lakhs (Rs. 1,000,000) and has a useful life of one year. The machine has the capacity to produce 1,000 toys per year.
- Variable cost per toy = Rs. 1,000
- Selling price per toy = Rs. 2,500
- Current market demand = 700 toys
⤷ Step 1: Variable Cost of Making 100 Toys
Formula:
Variable Cost (VC) = Quantity × Cost per unit
Calculation:
VC = 100 × 1,000 = Rs. 100,000
⤷ Step 2: Total Cost of Making 700 Toys
- Variable Cost (VC): 700 × 1,000 = Rs. 700,000
- Fixed Cost (FC): Rs. 1,000,000
- Total Cost (TC) = VC + FC:
TC = 700,000 + 1,000,000 = Rs. 1,700,000
⤷ Step 3: Average Cost per Toy
Formula:
Average Cost = Total Cost ÷ Quantity Produced
Calculation:
Average Cost = 1,700,000 ÷ 700 = Rs. 2,428.57
⤷ Step 4: Total Revenue from Selling 700 Toys
Formula:
Total Revenue = Quantity × Selling Price
Calculation:
Revenue = 700 × 2,500 = Rs. 1,750,000
⤷ Step 5: Profit from Selling 700 Toys
Formula:
Profit = Revenue − Total Cost
Calculation:
Profit = 1,750,000 − 1,700,000 = Rs. 50,000 (Profit)
Conclusion: ✔️ It is profitable to invest and manufacture 700 toys.
Scenario 2: What if Demand Is Only 600 Units?
⤷ Step-by-Step: Total Cost & Average Cost at 600 Toys
- VC = 600 × 1,000 = Rs. 600,000
- FC = Rs. 1,000,000
- Total Cost = VC + FC = 600,000 + 1,000,000 = Rs. 1,600,000
- Average Cost = 1,600,000 ÷ 600 = Rs. 2,666.67
⤷ Revenue from Selling 600 Toys
600 × 2,500 = Rs. 1,500,000
⤷ Profit/Loss Calculation
Profit = Revenue − Total Cost = 1,500,000 − 1,600,000 = Rs. -100,000 (Loss)
⤷ Do not invest if you know in advance that demand will be only 600 units. ❌
Post-Purchase Dilemma: Demand Revealed as 600 After Buying Machine
Now that you've already bought the machine:
Option 1: Make 600 Toys
- Total Cost = 1,000,000 (FC) + 600 × 1,000 (VC) = Rs. 1,600,000
- Revenue = 600 × 2,500 = Rs. 1,500,000
- Loss = Rs. 100,000
Option 2: Do Nothing
- Revenue = 0
- Loss = Rs. 1,000,000 (sunk fixed cost)
⤷ Better to produce and minimise loss to Rs. 100,000 than incur full loss of Rs. 1,000,000.
Option to Exit: Selling the Machine for Rs. 5 Lakhs
You now have two choices:
Option 1: Make Toys
- Total Cost = 1,600,000
- Revenue = 1,500,000
- Loss = Rs. 100,000
Option 2: Sell the Machine
- Revenue from sale = Rs. 500,000
- Loss = 1,000,000 – 500,000 = Rs. 500,000
⤷ Making toys reduces your loss to Rs. 100,000, so it's a better option compared to selling the machine.
⤷ Final Summary Table
| Scenario | Total Cost | Revenue | Profit/Loss |
|---|---|---|---|
| Produce 700 Toys | 1,700,000 | 1,750,000 | +50,000 |
| Produce 600 Toys (Pre-Purchase) | 1,600,000 | 1,500,000 | -100,000 |
| Produce 600 Toys (Post-Purchase) | 1,600,000 | 1,500,000 | -100,000 |
| Do Nothing After Purchase | 1,000,000 | 0 | -1,000,000 |
| Sell Machine for Rs. 5 Lakh | 1,000,000 | 500,000 | -500,000 |
