The AR-15 has been making headlines recently. It's produced by many firearms manufacturers, including Colt Manufacturing Company . Although they didn't design the AR-15, for many years Colt was responsible for all AR-15 production. Fast forward to today and they've made the decision to stop production of their AR-15. Why is a company that was once responsible for all AR-15 production choosing to stop manufacturing it now? With gun control a debate topic in this upcoming election, rumors are spreading that Colt wants to distance themselves from the AR-15. Could these rumors be true? There's one other fact that isn't making as many headlines, but can probably cue us in to what's really going on:
Colt is suspending its production of all rifles for the civilian market. Not just the AR-15.
After 183 years of manufacturing guns for civilians, has Colt suddenly decided that guns shouldn't be manufactured for civilians? This is highly unlikely. We can be fairly certain that ending civilian rifle production is a business decision for Colt. One that manufacturing businesses make all the time. To understand why, let's observe the forces of nature that are in play using basic economics as our lens.
THE ECONOMICS OF MANUFACTURING
Manufacturing businesses regularly make decisions as to whether they should continue manufacturing their products. How does a manufacturer know if it should continue producing a product?
In simple terms, if a business is able to sell a product for more than it costs to produce it, then it can choose to produce the product and make a profit.
Simple. But probably a little too simple. There are different types of costs, and different costs can matter whether you're making decisions for the short term or the long term. So, what costs influence decision marking?
Fixed Costs and Variable Costs
Every company has costs. It is true that you need to spend money in order to make money. Economists have come up with two meaningful ways to describe the costs that a business incurs during operation: fixed costs and variable costs. This way of looking at costs is particularly useful for manufacturing companies.
Total Cost = Total Fixed Costs + Total Variable Costs
Fixed Costs are costs that stay the same, even as you produce more or less. Fixed costs are committed costs, such as rent and salaries and overhead. If you're capable of producing up to 10,000 units, then your fixed costs will be the same whether you choose to produce 0, 1, or 10,000 units.
Variable Costs are costs that increase the more you produce. If your production capacity is 10,000 units, then your variable costs will be the lowest when you produce 0 units, and the highest when you produce 10,000 units.
Per-unit Price is the average price that an item sells for. Mathematically it can be expressed as
per-unit price = total price / number of units sold.
If 10 AR-15s will sell for a total price of $10,000, then their per-unit Price is
$10,000 / 10 AR-15s =
$1,000 per AR-15. In practice, the per-unit price can just be the list-price. If each AR-15 produced will sell with a price tag of $1,000, then the per-unit price is
$1,000 per AR-15. Depending on how a business does their accounting, any refunds, price-changes over time, and unsold inventories can complicate this. But let's not. For our purposes, let's assume each Colt AR-15 has a per-unit price of
$1,000 per AR-15. Note that per-unit price is what each unit sells for on average, not what the company pays to produce them.
In manufacturing, total costs can be spread out over large production quantities. So it's useful to look at costs on a per-unit basis.
Per-unit Fixed Cost is the fixed cost that a business incurs in order to produce one unit.
per-unit fixed cost = fixed cost / number of units produced.
Remember how fixed costs don't change the more you produce? The more units you produce, the lower your per-unit fixed costs are. Let's say Colt's fixed costs are
$10,000/day, and their production capacity for AR-15's is
100/day. If they produce just one AR-15 and call it a day, then on that day their per-unit fixed cost =
($10,000)/(1 AR-15) =
$10,000 per AR-15. But if they max out production and produce 100 AR-15's, then their per-unit fixed cost =
$100 per AR-15. As you can see, Colt's per-unit fixed cost will go down the more they produce. If they make just one AR-15 per day, then they'll have to sell them for at least $10,000 each to cover fixed costs. But if they make 100 AR-15s per day, then the per-unit price will need to be at least $100 to cover fixed costs. As far as per-unit fixed costs are concerned, it pays to produce more.
Per-unit Variable Cost is the variable cost that a business incurs in order to produce a certain number of units.
per-unit variable cost = variable cost / number of units produced.
The variable cost that is incurred to produce an additional unit is known as a marginal cost. Sometimes the marginal cost can change as you produce more and more units. But at constant production it can be treated as the same cost per-unit on average. We can treat Colt's per-unit variable cost as constant for our purposes. Let's say Colt's per-unit variable cost is
$500 per AR-15.
If they produce just a single AR-15 and call it a day, then the total variable cost for producing 1 AR-15 is
(per-unit variable cost)*(number of units produced) =
$500/AR-15 * (1 AR-15)=
$500. If they max out capacity and produce 100 AR-15s in a day, then the total variable cost for producing those 100 AR-15s is
(per-unit variable cost)*(number of units produced) =
$500/AR-15 * (100 AR-15s)=
$50,000. How does per-unit variable cost relate to total variable cost? As you produce more units, the per-unit variable cost stays the same, but the total variable cost increases.
Just like total cost = fixed cost + variable cost, per-unit Total Cost =
per-unit fixed cost + the per-unit variable cost. It's the total cost that a business incurs in order to produce one unit. Both fixed costs and variable costs factor in to the per-unit Total Cost. And it's higher at lower poduction quantities.
One final cost
People make choices between things. There is a hidden cost that you make with every decision that you make. When you make a choice to do something, there are probably other things that you could have chosen to do instead. The opportunity cost is the highest value of the other options that you could have chosen instead of the one you chose.
Let's say Colt has a production capacity of
100 guns / day and they have manufactured 99 guns so far today. For their final gun, they produce a particular gun model that will sell at a marginal profit of
$300. Sounds great, right? They made money, didn't they? Well, that decision carries an opportunity cost. Let's say there's a different gun model that they could have produced instead with a marginal profit of
$600. In this scenario, the opportunity cost of producing a gun that brings in $300 in additional profit is
$600 . Without considering the opportunity cost, they don't know that they could have done better by producing a different gun. This opportunity cost is a variable cost. They incur this kind of opportunity cost for each additional gun that they manufacture.
The Advantages and Disadvantages of Production at Scale
As you increase production, your per-unit variable cost may stay the same, but your per-unit fixed cost reduces. So as you increase production, your per-unit total cost may reduce. If most of your costs are fixed costs, then as you increase production, your per-unit total cost can drastically reduce. Manufacturing companies with relatively high fixed costs produce items in large quantities in order to take advantage of the nature of fixed costs to increase profits.
These cost advantages over larger production quantities are known as economies of scale. They're the reason airplane tickets can be relatively cheap, considering passenger airplanes cost hundreds of millions of dollars and a single flight uses tens of thousands of dollars of gasoline. Due to their impact on per-unit total cost as well as being a barrier to entry, fixed costs are wonderful when more and more people are buying your products.
However fixed costs make up total costs and in order to cover total costs you need to produce at least the quantity known as the minimum efficient scale of operation. Only use the plane once and fly just a single passenger, and the plane ticket will have to be over $100,000,000 just to cover costs. Fly multiple times per day with a full plane and a single plane ticket can be just a couple hundred dollars to cover costs. So fixed costs are a burden when less and less people are buying your products. They're also a burden when new technology makes the fixed costs unnecessary for new competitors to compete.
When do you decide to halt production?
One must know when to stop. Knowing when to stop averts trouble.
― Lao Tsu
Earlier I wrote "if a business is able to sell a product for a higher price than it costs to produce it, then it can choose to produce the product and make a profit." Now that we know how economists and managers like to look at costs, which costs matter when deciding when to produce? How does all of this play into Colt deciding not to produce civilian rifles anymore?
When the fixed costs are already paid for, they should not matter in future decision making. These are known as sunk costs, and you should let bygones be bygones.
In practice, fixed costs are already committed in the short-run. This means that in the short-run, when considering whether to produce, variable costs are all that matter. In the short-run, you should continue to produce when you can cover variable costs, or when:
per-unit Price > per-unit Variable Cost
In the long-run, when considering whether to produce, fixed costs matter as well. They haven't been committed yet in the long-run, so you should continue to produce when you can cover both the fixed and the variable costs, or when:
per-unit Price > per-unit Total Cost
So why is Colt shutting down production?
Let's ignore Colt's recent bankruptcy and assume that Colt is a well-managed profit-maximizing firm.
- A manufacturing plant is capable of producing more than one product. We can assume that Colt manufactures multiple rifles for different markets in some of the same manufacturing plants, not just civilian rifles like the AR-15.
- Colt's military and law enforcement weapons are paid for by steady government contracts, but their civilian rifle sales are subject to the consumer market.
Knowing this, and the microeconomic principles covered in this article, what can we infer about Colt's decision to stop production of all rifles for the civilian market?
It's likely that in recent years, sales of Colt's civilian rifles have not been as high as they once were. There's new competition offering cooler guns or lower priced guns, or there are just a lot of guns on the market, much more supply than is demanded. Despite the declining sales of Colt's civilian rifles, and increasing opportunity costs of producing the civilian rifles, each year Colt has been able to cover their per-unit Variable Costs of producing civilian rifles. So they have continued to produce. However, more time has gone by and decisions need to be made again. This time around, there's two possibilities. Both with the same outcome.
- Possibility 1: They're looking at the next year or accounting period and they're unable to cover these per-unit variable costs of producing civilian rifles for the short-run. There is downward pressure on per-unit price, and their opportunity costs are going up as they could be producing guns that will bring in more revenue.
- Possibility 2: They're looking into the foreseeable future and they're unable to cover the per-unit total costs of producing civilian rifles in the long-run. Fixed costs such as building leases and factory wages are up for renewal. They now have to be factored in to their decision-making, raising the bar of minimum profitability for all of their guns.
So they have chosen to postpone production of civilian market rifles. They may have had no other choice, since a surplus of unsold inventory may have required them to reduce total production to a point where they no longer have a minimum efficient scale of operation. This would be worse than just shutting down production of civilian rifles, reclaiming the opportunity cost, putting those resources towards the more profitable government weapons, and supplying civilian rifles from stockpiled inventory to meet lower consumer demand for their rifles, while maintaining a profitable per-unit price.
We came to this conclusion inferring from basic economics. How does this align with what Colt's CEO is saying from the trenches?
“We want to assure you that Colt is committed to the Second Amendment. ... . The fact of the matter is that over the last few years, the market for modern sporting rifles has experienced significant excess manufacturing capacity. Given this level of manufacturing capacity, we believe there is adequate supply for modern sporting rifles for the foreseeable future.”
– Dennis Veilleux, CEO, Colt.
Comes to show the power of applying basic microeconomics. Colt is a firearms manufacturer. They make guns for a living. Ending civilian rifle production is likely a business decision for Colt, not a political one. They're not selling their civilian rifles fast enough to justify producing more of them in the quantities that they can afford to produce. Companies discontinue lower margin products all the time to focus on products with higher margins.
Dennis' statement is in direct response to rumors that external pressures are the reason for stopping civilian rifle production. How do you think this will play out? Will gun-buyers see this as an attack on the 2nd amendment and retaliate by boycotting Colt firearms?
 Founded in 1855, Colt Manufacturing Company rose to prominence through their contributions to conflicts spanning the 1850's through World War 1, and to the field of manufacturing. Their manufacturing dates back to 1836 and their weapons have been used in many historical conflicts throughout the world. They're primarily known for their handguns, and they manufacture the longest-standing service handgun, the M1911, which has been in service since 1911.