Question

Apple, Inc. is one of the world’s largest companies in terms of market capitalization. The company recently reported quarterly earnings that exceeded Wall Street’s expectations. However, management is concerned about the next quarter and year, primarily related to the effects of the Coronavirus on production of three product lines in its Chinese factories: iPhones, Macs/iPads, and AirPods. In particular, senior leadership predicts that the virus may reduce the number of workers available to operate machines and therefore impose a constraint on operator hours, which are used across iPhones, Macs/iPads, and AirPods. The Coronavirus is expected to limit the number of operator hours available to 1.15 billion for 2020. As the figures below show, this number of operator hours is not large enough to allow Apple to fill maximum 2020 demand for all three product lines.

Following are projections for calendar year 2020 (except for 2019 production volume). Direct materials and direct labor are variable costs. Estimated service cost is also a variable cost that represents anticipated service commitments over the useful life of the product.

The fixed overhead (per unit) is the result of allocating total fixed costs, which relates entirely to production costs, across product lines based on relative sales value and 2019 production levels. Assume that total fixed costs are not expected to change between 2019 and 2020.

	iPhone	Mac/iPad	AirPods
Dollars amounts are per unit
Average sales revenue	$800	$1,200	$160
Direct materials	$160	$380	$25
Direct labor	$60	$140	$15
Estimated service cost	$50	$90	$0
Allocated fixed overhead	$170	$255	$34
2019 production volume (millions)	150	39	41
Maximum 2020 demand (millions)	155	38	62
Operator hours per unit	5	9	2

(For each question, calculate product mix and operating income for the year 2020, as applicable)

1. Apple routinely emphasizes gross margin percentage as one of its key performance indicators both internally and in external reports and communications (e.g., press releases, conference calls). In turn, the company’s current approach is to allocate constrained resources to products based on gross margin percentage as it believes this will maximize net operating income. Calculate the gross margin percentage for each product.
2. Suppose that when total production is constrained, Apple chooses its product mix by filling demand for products with the highest gross margin percentage and leaving some demand unfilled for products with the lowest gross margin percentage. What mix of products would Apple produce under this approach and what would operating income be for this mix?
3. Despite Apple’s internal and external emphasis on gross margin percentage, you are skeptical that this emphasis is the best way to make product mix decisions when production is constrained assuming the goal is to maximize profit. Suggest a better way to determine the product mix that maximizes profit. Then calculate this alternative product mix, the operating income for this mix, and compare operating income to the amount calculated in question 2.
4. Apple is also concerned with assessing what will happen if the effects of the Coronavirus on available operator hours is larger or smaller than the amount reflected in the original estimate of 1.15 billion hours. Answer the following, assuming that under either alternative the product mix will be adjusted to maximize profitability:
   1. how much would operating income decrease if the number of available hours is 50 million hours lower than the original estimate, so that the total available hours are 1.10 billion hours?
   2. how much would operating income increase if the number of available hours is 100 million hours higher than the original estimate, so that the total available hours are 1.25 billion hours?

Answer 1

Points to be noted:

Between alternative 1 & 2 the total operating income didn't change as the rank under contribution method and gross margin method remained the same.

But in solution to Question a. There is constraint in labour hrs as it decreased by 50 Mn, hence the profit also declined $3 Bn as the fixed cost of air pods couldn't be absorbed and less sales in units of Mac.

But there is a increase in net income of $9 Bn under Q. b. as compared to solution in Q. a as there is excess capacity of labour hours.

It is always better to use contribution margin method to calculate product mix problems that any other basis, because contribution gives the net available portion post deduction of all variable cost and most cases fixed cost are allocated and unavoidable

1 Calculation of operating income under Gross Margin% iPhone Mac/iPad AirPods 38 62 5 9 2 Maximum 2020 demand (millions) Operator hours per unit 155 1,150 Hrs available Average sales revenue Less: Less: Direct materials Direct labor Gross Margin Rank $800 $160 $60 $580 2 $1,200 $380 $140 $680 1 $1601 $25 $15 $120 3 allocation of Labour hours 775 155 342 38 33 17 Balance available after 33 allocating to iphone & Mac Units to be produced Estimated service cost Operating income under Gross Margin method Total Operating income in ($000,000) Fixed Cost@2019 Production Levels Net Operating income $50 $530 $82,150 $25,500 $56,650 $90 $590 $22,420 $9,945 $12,475 $0 $120 $1,980 $1,394 $586 $106,550 Less: $69,711

2 Calculation of operating income under Contribution Margin Maximum 2020 demand (millions) Operator hours per unit iPhone Mac/iPad AirPods 155 38 62 5 9 2 1,150 Hrs available Average sales revenue $800 $1,200 $160 Less: Less: Less: Direct materials Direct labor Estimated service cost Contribution Key Factor - Contribution/Labour hrs Rank $160 $60 $50 $530 106 1 $380 $140 $90 $590 66 2 $25 $15 $0 $120 60 allocation of Labour hours 775 155 Balance available after 33 allocating to iphone & Mac 342 38 33 17 Units to be produced Total Contribution $82,150 $22,420 $1,980 Less: Fixed Cost@2019 Production Levels Total Operating income in ($000,000) $25,500 $56,650 $9,945 $12,475 $1,394 $586 $69,711

4 Calculation of operating income under Contribution Margin Maximum 2020 demand (millions) Operator hours per unit iPhone Mac/iPad AirPods 155 38 62 5 9 2 1,250 Average sales revenue $800 $1,200 $160 Less: Less: Less: Direct materials Direct labor Estimated service cost Contribution Key Factor - Contribution/Labour hrs Rank $160 $60 $50 $530 106 1 $380 $140 $90 $590 66 2 $25 $15 $0 $120 60 3 allocation of Labour hours 775 155 342 124 133 38629 Units to be produced Total Contribution $82,150 $22,420 $7,440 Less: 25,500 9,945 1,394 Fixed Cost@2019 Production Levels Operating income under Gross Margin method Total Operating income/Loss in ($000,000) $56,650 $12,475 $6,046 $75,171

3 Calculation of operating income under Contribution Margin with reduction in labour Hrs Maximum 2020 demand (millions) Operator hours per unit iPhone Mac/iPad AirPods 15538 62 592 ༄༅ 1,100 Hrs available Average sales revenue $800 $1,200 $160 Less: Less: Less: Direct materials Direct labor Estimated service cost Contribution Key Factor - Contribution/Labour hrs Rank & & # ་ 5160 $380 $25 s60 140 :15 $50 $30 $530 $590 $120 1066660 __ 2 allocation of Labour hours 775 155 Balance available after 325 allocating to iphone & Mac 342 36 Units to be produced Total Contribution $82,150 $21,306 $0 Less: Fixed Cost@2019 Production Levels Total Operating income/Loss in ($000,000) 25,500 $56,650 9,945 1,394 $11,361 ($1,394) $66,617