Question

Cost function; breakeven; targeted profit; uncertainties and bias; interpretationJoe Davies is thinking about starting a company to produce carved wooden clocks. He loves making the clocks. He sees it as an opportunity to be his own boss, making a living doing what he likes best. Joe paid $300 for the plans for the first clock, and he has already purchased new equipment costing$2000 to manufacture the clocks. He estimates that it will cost $30 in materials (wood, clock mechanism, etc.) to make each clock. If he decides to build clocks full time, he will need to rent office and manufacturing space, which he thinks would cost $2500 per month for rent plus another $300 per month for various utility bills. Joe would perform all of the manufacturing and run the office, and he would like to pay himself a salary of $3000 per month so that he would have enough money to live on. Because he does not want to take time away from manufacturing to sell the clocks, he plans to hire two salespeople at a base salary of $1000 each per month plus a commission of $7 per c l o c k. Joe plans to sell each clock for $225. He believes that he can produce and sell 300 clocks in December for Christmas, but he is not sure what the sales will be during the rest of the year. However, he is fairly sure that the clocks will be popular because he has been selling similar items as a sideline for several years. Overall, he is confident that he can pay all of his business costs, pay himself the monthly salary of $3000, and earn at least $4000 more than that per month. (Ignore income t a x e s.)

Required: (a)Perform analyses to estimate the number of clocks Joe would need to manufacture and sell each year for his business to be financially successful:

    (i)List all ofthe costs described and indicate whether each cost is (1) a relevant fixed cost, (2) a relevant variable cost or (3) not relevant to Joe’sdecision.

    (ii)Calculate the contribution margin per unit and the contribution margin ratio.

    (iii)Write down the total cost function for the clocks and calculate the annual breakeven point in units and in revenues.

    (iv)How many clocks would Joe need to sell annually to earn $4000 per month more than his salary?

(b) Identify uncertainties about the CVPcalculations:

(i)Explain why Joe cannot know for sure whether his actual costs will be the same dollar amounts that he estimated. In your explanation, identify as many uncertainties as you can. (Hint: For each of the costs Joe identified, think about reasons why the actual cost might be different than the amount he estimated.)

(ii)Identify possible costs for Joe’s business that he has not identified. MAF 200116-Session2, 2020GroupassignmentPage 2of 11List as many additional types of cost as you can.              (iii)Explain why Joe cannot know for sure how many clocks he will sell each year. In your explanation, identify as many uncertainties as you can.

(c)Discuss whether Joe is likely to be biased in his revenue and cost estimates.

(d)Explain how uncertainties and Joe’s potential biases might affect the interpretation of the breakeven analysis results

Answer 1

Solution :

Parti : Types of Cost : Cost Amount Classification Reason Paid for Plans 300 Not relevant Sunk cost Already bought equipment $ 2,000 Not relevant Sunk cost Materials per unit $ 30 Relevant Variable cost To be incurred Rent per month $ 2,500 Relevant Fixed cost Remains fixed every month Utility bills per month $ 300 Relevant Fixed cost Remains fixed every month Salary per month $ 3,000 Relevant Fixed cost Remains fixed every month 2 Sales people per month 2,000 Relevant Fixed cost Remains fixed every month Commission to Sales people $ 7 Relevant Variable cost Varies with the unit Selling price $ 225 Relevant Revenue Varies with the unit Part ü : Contribution per unit 225 Selling price per unit Less : Variable Costs Materials p.u Commission p.u Contribution p.u $ $ $ 30 7 188 Contrinution margin ratio : = [ Contribution + Sales ] x 100 = [188 = 225 ] x 100 = 83-56% Part ïï: Cost Function C(x)= FC(x) + V(x) Relevant Fixed cost Relevant Variable cost C(x) = $7800 + $37x 7,800 CA A 37

Break even point : Units = Fixed cost : Contribution p.u = $7800 = $ 188 = 42 units (rounded off) Break even point in value : = Break even point x Selling price p.u = 42 x $225 $9,450 *Note: If the formula Break even point divided by contribution margin ratio is used, the value will be $9,335. The difference is due to rounding off. Part iv : Annual sales to earn $4000 profit Units = [Fixed cost + Desired return] Contribution p.u =[ $7,800 + $4,000] = $ 188 = 63 units (rounded off)

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