Question

You operate a lemonade stand. The wholesale cost of lemonade is $0.50 per unit. The cost of rent for the stand is $30 per day. You need to choose your pricing and advertising strategy. You are considering three alternatives: A: If you set the selling price to $1.50 per unit and spend $0 on advertising, you will sell 160 units per day. B: If you reduce the selling price to $1.20 per unit and spend $0 on advertising, you will sell 240 units per day. C: If you set the selling price to $1.50 per unit and spend $30 per day on advertising, you will sell 240 units per day. a) Compute revenue, costs, and profit per day for each alternative. Costs: Lemonade (wholesale) Rent chvrisi Profit b) Which alternative should you choose? OB O C c) Is rent a relevant cost? NO (the cost is the same for all three alternatives; it can be ignored) O YES (the cost differs across alternatives; it should not be ignored) d) Is advertising a relevant cost? O YES (the cost differs across alternatives; it should not be ignored) NO (the cost is the same for all three alternatives; it can be ignored)

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Answer 1

a)

	A	B	C
Revenue (i)	160 x 1.50 = $240	240 x 1.20 = $288	240 x 1.50 = $360
Costs:(ii)
Lemonade	160 x 0.50 = 80	240 x 0.50 = 120	240 x 0.50 = 120
Rent	30	30	30
Advertising	0	0	30
Profit (i) - (ii)	$130	$138	$180

b)

Since profit is maximum is option C, hence option C must be chosen

c)

Rent is not a relevant cost since rent is same for all the three alternatives, it can be ignored. Cost which does not change in different alternatives, is not a relevant cost in decision making.

d)

Advertising is a relevant cost since advertising differs across different alternatives, it should not be ignored. Cost which changes id different alternatives, is a relevant cost in decision making.

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