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A company has a target mark up of 25% and sells into a competitive market where the market price is $120 per unit. The company’s current costs per unit are $46 for variable and $60 for fixed and a budget out put of 10,000 units.
What is the production required to close the target cost gap.
Answer =12,000 units.
In the example answer provided the fixed cost has been reduced to $50 to arrive at the 12,000. I don’t understand why reducing the fixed cost is even possible, by nature the fixed cost is fixed.
Would you be able to explain the theory behind the solution please. Many thanks in advance
If the target mark up is 25% (i.e. 25% on cost), then with a selling price of $120 the target cost is 100/125 x 120 = $96.
Therefore they need the fixed cost per unit to be 96 – 46 = $50 per unit.
By definition, the total fixed costs will stay the same as budgeted, which is 10,000 x $60 = $600,000.
In order for the fixed costs to be absorbed as $50 per unit, they need to produced 600,000 / 50 = 12,000 units.
Fixed costs are fixed in total, but the fixed costs absorbed per unit depends on the level of production.
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