Question

Question 5: Relevant information for decisions (20 marks in total)

Digg Limited is a small firm involved in the production and sale of electronic business products. The company is well known for its attention to quality and innovation

During the past 15 months, a new product has been under development that enables a hand-held device to scan a 3D object and send the scan to a remote 3D printer for printing. Digg Limited named the product ‘3D Wizard’ and has been quietly designing two models: Standard and enhanced. Development costs have amounted to $181,500 and $262,500 respectively. The total market demand for each model is expected to be 40,000 units, and management anticipates being able to obtain the following market shares: Standard 25%; Enhanced 20%.

Forecast data follow:

	Standard	Enhanced
Projected Selling Price	$375.00	$495.00
Production cost per unit:
Direct material	42.00	67.50
Direct Labour	22.50	30.00
Variable overhead	36.00	48.00
Fixed overhead	54.00	42.00
Marketing and advertising per product line	195,000	300,000
Sales salaries per product line	85,500	85,500
Sales commissions (% of sales dollars)	10%	10%

Since the start of the development work on the 3D Wizard, advances in technology have altered the market somewhat, and management now believes that the company can introduce only one of the two models. Consultants confirmed this fact not too long ago, with Digg Limited paying $34,500 for an in-depth market study.

Required:

1. Calculate the per unit contribution margin for both models.
2. Which of the data above should be ignored in making the product introduction decision? For what reason?
3. Prepare a financial analysis and determine which of the two models should be introduced.
4. What other factors should Digg consider before a final decision is made?

Answer 1

Answer 1:

Per unit contribution margin for both models is calculated as below:

Answer 2:

The data that should be ignored are:

• Amount paid for an in-depth market study =$34,500
• Development costs amounted to $181,500 and $262,500 respectively

Reason:

These amounts have already been spent. In evaluation for making the product introduction decision, the relevant costs that will be incurred on introduction of model should only be considered. Such relevant/incremental costs can be both fixed costs and variable costs. But costs that have already been incurred are no longer relevant as these costs are incurred irrespective of whether products or one product introduced or not. The costs that are already incurred are sunk costs.

Answer 3:

Based on data given and expected market demand of 40,000 units for each model:

We observe that contribution as well as net operating profit of 'Enhance Model' is higher. Based on financial analysis 'Enhance Model' should be introduced.

Answer 4:

Other factors should Digg consider before a final decision is made are:

1. Whether non-introduction of standard model will affect the sales expectation of 'Enhance Model'?

2. Will it involve purchase of new machineries and increase in working capital ?. The company should review and evaluate any initial investment is required. The company should get all relevant data to do future cash flow analysis , calculate NPV based on cost of capital and evaluate. This should include sensitivity analysis.

3. Will it be prudent to introduce 'enhance model' without a 'standard model' ?

4. As the technology is fast changing, company should factor in this and evaluate possible scenarios.