Midwestern Sod Company produces two products; fescue grass and Bermuda grass. Fe
ID: 2434269 • Letter: M
Question
Midwestern Sod Company produces two products; fescue grass and Bermuda grass.Fescue Grass Bermuda Grass
Selling price per square yard $2.00 $2.85
Less variable cost per square year .55 $1.15
The company has 120,000 square yards of growing space available. In the past year, the company dedicated 60,000 square yards to fescue and 60,000 square yards to Bermuda grass. Annual fixed costs are $120,000, which the company allocates to products based on relative growing space.
Martha Lopez, the chief financial officer of Midwestern Sod, has suggested that in the coming year, all 120,000 square yards should be devoted to Bermuda grass. The president vetoed her suggestion, saying. “I know that right now home construction is booming in our area, and we can sell all the grass we can produce, irrespective of what type. But, you know a lot of developers really like that fescue grass and I’d hate to disappointment them by not offering it.”
Required:
What is the opportunity cost of the president’s decision to stick with both types of grass?
Explanation / Answer
The opportunity cost is the profit forgone by making the decision to not grow all Bermuda grass, but to continue growing both Fescue and Bermuda grass. There may be very good reasons in the long term for the decision the company made, but there is a short term cost. To calculate the opportunity cost, you need to calculate what the profitability would be for the 60,000 yard2 under both possible choices, continuing to grow Fescue, and switching to grow Bermuda. The other 60,000 yard2, already growing Bermuda, is not part of the calculation. Fescue Bermuda Sales Price/Yard2 $ 2.00 $ 2.85 Var. Cost/Yard2 $ 0.55 $ 1.15 Fixed Cost/Yard2 $ 60,000.00 $ 60,000.00 Revenue $ 120,000.00 $ 171,000.00 Variable Cost $ (33,000.00) $ (69,000.00) Fixed Cost $ (60,000.00) $ (60,000.00) Profit $ 27,000.00 $ 42,000.00 Opportunity Cost = $ 15,000.00 The firm is giving up an additional $15,000 of profit by not switching from Fescue to Bermuda for the second 60,000 yard2.