Question

Luke Corporation produces a variety of products, each within their own division. Last year, the managers at Luke developed and began marketing a new chewing gum, Bubbs, to sell in vending machines. The product, which sells for $5.75 per case, has not had the market success that managers expected and the company is considering dropping Bubbs.

The product-line income statement for the past 12 months follows:

Revenue				$	14,697,150
Costs
Manufacturing costs	$	14,445,395
Allocated corporate costs (@5%)		734,858			15,180,253
Product-line margin				$	(483,103	)
Allowance for tax (@20%)					96,620
Product-line profit (loss)				$	(386,483	)

All products at Luke receive an allocation of corporate overhead costs, which is computed as 5 percent of product revenue. The 5 percent rate is computed based on the most recent year’s corporate cost as a percentage of revenue. Data on corporate costs and revenues for the past two years follow:

	Corporate Revenue		Corporate Overhead Costs
Most recent year	$	116,750,000	$	5,837,500
Previous year		77,200,000		4,935,760

Roy O. Andre, the product manager for Bubbs, is concerned about whether the product will be dropped by the company and has employed you as a financial consultant to help with some analysis. In addition to the information given, Mr. Andre provides you with the following data on product costs for Bubbs:

Month	Cases	Production Costs
1	217,000	$1,156,840
2	222,200	1,178,340
3	219,900	1,186,993
4	238,000	1,202,535
5	229,950	1,204,839
6	247,000	1,225,685
7	225,250	1,200,711
8	252,200	1,243,786
9	243,800	1,242,238
10	257,650	1,254,337
11	255,200	1,258,772
12	264,200	1,289,463

Required:

a. Bunk Stores has requested a quote for a special order of Bubbs. This order would not be subject to any corporate allocation (and would not affect corporate costs). What is the minimum price Mr. Andre can offer Bunk without reducing profit any further?

b. How many cases of Bubbs does Luke have to sell in order to break even on the product?

c. Suppose Luke has a requirement that all products have to earn 5 percent of sales (after tax and corporate allocations) or they will be dropped. How many cases of Bubbs does Mr. Andre need to sell to avoid seeing Bubbs dropped?

d. Assume all costs and prices will be the same in the next year. If Luke drops Bubbs, how much will Luke’s profits increase or decrease? Assume that fixed production costs can be avoided if Bubbs is dropped.

Answer 1

a. Bunk Stores has requested a quote for a special order of Bubbs. This order would not be subject to any corporate allocation (and would not affect corporate costs). What is the minimum price Mr. Andre can offer Bunk without reducing profit any further?

Ans : The cost of the product is 5.652 hence that is the minimum price which can be offered which wont reduce profit further

Particulars	Total Amount	Number of Unit	Price per Unit
Revenue	14,697,150.00	2,556,026.09	5.75
Cost	14,445,395.00	2,556,026.09	5.652
Contribution	251,755.00	2,556,026.09	0.098

b. How many cases of Bubbs does Luke have to sell in order to break even on the product?

Ans : In the given circumstance corporate allocation is only fixed cost.

Breakeven sales unit = Fixed cost / contribution per unit

7,460,889 = 734858 / 0.098

c. Suppose Luke has a requirement that all products have to earn 5 percent of sales (after tax and corporate allocations) or they will be dropped. How many cases of Bubbs does Mr. Andre need to sell to avoid seeing Bubbs dropped?

Considering current contribution, corporate allocation and taxes, it is not possible to achieve sales margin beyond 1.37% of sales :

Below is example when we sale 1000 time of breakeven sales unit

Number of Units	74,608,894,290.43
Sales	429,001,142,169.97
Cost	421,652,562,169.97
Contribution	7,348,580,000.00
Corporate Allocation	(734,858.00)
Profit before tax	7,347,845,142.00
Tax @ 20%	(1,469,569,028.40)
Profit after Tax	5,878,276,113.60
Net profit to Sales Ratio	1.37%

d. Assume all costs and prices will be the same in the next year. If Luke drops Bubbs, how much will Luke’s profits increase or decrease? Assume that fixed production costs can be avoided if Bubbs is dropped.

Ans : Assuming drops of bubbs have no impact on decrease of corporate allocation, the profit before tax would reduce by 251,755 (current contribution). Further if fixed production costs can be avoided, profit before tax will increase to such extent (its not possible to quantify such amount since information is not provided here)