At a recent board meeting, the president and CEO got into a heated argument about whether to shut down the firm’s plant in Miami. The Miami plant currently loses $60,000 monthly. The president of the firm argued that the Miami plant should continue to operate, at least until a buyer is found for the production facility. The president’s argument was based on the fact that the Miami plant’s fixed costs are $68,000 per month. The CEO exploded over this point, castigating the president for considering fixed costs in making the shutdown decision. According to the CEO, “Everyone knows fixed cost don’t matter!”

a) Should the Miami plant be closed or continue to operate at a loss in short run?
b) How would you explain to the incorrect party that he or she is wrong?

a) In order to determine whether the Miami plant should be closed or continue to operate at a loss in the short run, we need to consider both the variable costs and the fixed costs associated with the plant. Variable costs are costs that change with the level of production, while fixed costs are costs that remain constant regardless of the level of production.

Since the Miami plant is currently losing $60,000 per month, we need to compare this loss with the fixed costs of $68,000 per month. If the loss of $60,000 is less than the fixed costs of $68,000, it would make financial sense to keep the plant open in the short run. This is because despite the loss, the plant is still covering a significant portion of its fixed costs. By continuing to operate, the firm can reduce the loss and potentially find a buyer for the production facility.

b) To explain to the CEO that he is incorrect in dismissing the importance of fixed costs, we can provide a simple analogy. Let's say you decide to open a lemonade stand. You have to pay a fixed cost of $100 to rent the space for the stand, regardless of how much lemonade you sell. On top of that, you have variable costs such as the cost of lemons, sugar, and cups, which change depending on the number of cups of lemonade you sell.

Now, consider if you were only selling 10 cups of lemonade per day and each cup brings in $5. If you were to only consider the variable costs, you might think that you're losing money because the cost of lemons, sugar, and cups might add up to $3 per cup. However, when you factor in the fixed cost of $100, you can see that even though you're not making a profit, you're still covering a significant portion of your fixed cost.

Similarly, in the case of the Miami plant, the CEO's statement that "fixed costs don't matter" is incorrect. Fixed costs are an important consideration because they represent the baseline costs that need to be covered for the plant to remain operational. By factoring in both fixed costs and variable costs, a more accurate decision can be made regarding whether to close or continue operating the Miami plant.