Question

7.7 a. (5 points) Default Transmissions, Inc., has the following estimates for its new gear assembly project: price = $1,400 per unit; variable costs = $140 per unit; fixed costs = $7 million; quantity = 80,000 units. Suppose the company believes all of its estimates are accurate only to within +25 percent. What values should the company use for the four variables given here when it performs its best-case scenario analysis? What about the worst-case scenario? b. (5 points) For the company in part a, suppose management is most concerned about the impact of its price estimate on the project's profitability. How could you address this concern for Default Transmissions? Describe how you would calculate your answer. What values would you use for the other forecast variables?

Answer 1

Ans. a)

Best Case scenario,

Projects Earning will Be higher by 25% Expense will lower by 25%. (Basically revenue parametre goes up expense goes doen)

Price = 1400 * (1+ 25%) = 1400*1.25 = 1750 each Unit

Fixed Cost = $7 Million * (1 - 25%) = $7 Million * 0.75 = $ 5.25 Million

Variable Cost = 140 * (1 - 25%) = 140 * 0.75 = $ 105

Quantity = 80,000 * (1+ 25%) = 80,000*1.25 = 100,000 Units

Worst Case scenario,

Projects Earning will Be lower by 25% Expense will higher by 25%.

Price = 1400 * (1 - 25%) = 1400* 0.75 = 1050 each Unit

Fixed Cost = $7 Million * (1 +25%) = $7 Million * 1.25 = $ 8.75 Million

Variable Cost = 140 * (1 + 25%) = 140 * 1.25 = $ 175

Quantity = 80,000 * (1 - 25%) = 80,000*0.75 = 60,000 Units

Ans. b)

To address this concern we should do break even analysis of the on price per unit of this project. And for break even analysis we should use default values & Worst Case scenario too (Conservative approach)

At break-even point, (Normal Scenario)

Total Revenue = Total Cost

Assume Price of each unit = P

Quantity * Price = Fixed Cost + Variable Cost

80,000* P = 7000000 + 80,000*140 ( Variable Cost = 80,000*140)

P = 227.5

At break-even point, (Worst Case scenario)

Total Revenue = Total Cost

Assume Price of each unit = P

Quantity * Price = Fixed Cost + Variable Cost

60,000 * P = 87,50,000 + 60,000* 175  ( Variable Cost = 60,000* 175 )

P = 320.83

But even worst case scenario also estimated price is $ 1050per Unit

So management should go ahead with the project.