Question

The director of a nonprofit foundation that sponsors 8-week summer institutes for graduate students analyzed the costs and expected revenues for the next summer institute and recommended that the session be canceled. In her analysis she included a share of the foundation’s overhead – the salaries of the director and staff and costs of maintaining the office – to the program. She estimated costs and revenues as follows: Projected revenues (from tuition and fees) $300,000 Projected costs Overhead $50,000 Room and board for students $100,000 Costs for faculty and miscellaneous $175,000 Total costs $325,000 What was the error in the director’s recommendation?

Answer 1

The director incorrectly included fixed overhead costs in her analysis when assessing the viability of the summer institute, failing to recognize these costs would persist regardless of the decision to hold the session. The institute would generate sufficient revenue to cover variable costs and contribute to fixed costs.

Step-by-step explanation:

The error in the director’s recommendation to cancel the summer institute lies in the improper allocation of fixed costs to the decision-making process regarding whether to hold the session or not. The financial analysis provided includes a share of the foundation’s overhead costs, which are fixed costs and will not change whether the institute operates that summer or not. The revenues from tuition and fees during the 8-week summer institutes amount to $300,000, while variable costs (such as room, board, and faculty costs) total $275,000.

If the director includes the $50,000 of fixed overhead costs in the decision, the total costs ($325,000) appear to exceed the projected revenues, implying a loss. However, these overhead costs will be incurred no matter what, and by not holding the institute, the organization effectively forgoes net revenues of $25,000 ($300,000 in revenues minus $275,000 in variable costs). Therefore, from a financial standpoint, it may make sense to continue with the program as the additional revenue covers the variable costs and contributes $25,000 towards the fixed costs.

Another example for comparison is the Yoga Center scenario. Here, the center needs to decide if operating makes financial sense given their fixed and variable costs. In a situation where the center earns revenues of $20,000 and variable costs are $15,000, operating makes sense since revenue exceeds variable costs and contributes to fixed costs, even though a total profit is not achieved. Thus, the Yoga Center should continue in business.