Question

1. Last year, Leeky’s Pizza Ovens sold its ovens at a price of $800 each. The variable expenses for each oven were $500 and the annual fixed expenses totaled $270,000. Leeky’s Pizza Ovens had targeted a profit of $300,000 for the year but fell substantially short of that goal because product demand shifted resulting in sales of only 1,600 ovens. Leeky’s president assigned a management committee to analyze the situation and develop alternative courses of action for the coming year. The following three alternatives were presented to the president, but only one can be selected:

Alternative A: Reduce the selling price by $70. The marketing department forecasts that with the lower price, 2,400 ovens could be sold during the year.

Alternative B: Lower variable expenses per unit by $25 through the use of less expensive materials. Because of the difference in materials, the selling price would have to be lowered by $50 and sales of 2,100 ovens for the year are forecast.

Alternative C: Cut fixed expenses by $50,000 and lower the selling price by 5 percent. Sales of 2,000 ovens would be expected for the year. If no changes are made to the selling price and cost behavior is unchanged, estimate the number of ovens that must be sold during the year to break even. If no changes are made to the selling price and cost behavior is unchanged, estimate the number of ovens that must be sold during the year to attain the target profit of $300,000.

Determine which of the alternatives Leeky’s Pizza Ovens’ president should select to maximize profit.

Answer 1

Evaluation of three alternatives:

	Given data	Alternative A	Alternative B	Alternative C
a. Sales in units	1,600	2,400	2,100	2,000
b. Selling price per oven	$800	$730 ($800 - $70)	$750 ($800 - $ 50)	$760 ($800 * 95%)
c. Sales Revenue (a * b)	$1,280,000	$1,752,000	$1,575,000	$1,520,000
d. Variable Expense	$800,000 (1,600 * $500)	$1,200,000 (2,400 * $500)	$997,500 (2,100 * $475)	$1,000,000 (2,000 * $500)
e. Fixed Expense	$270,000	$270,000	$270,000	$220,000 ($270,000 - $50,000)
f. Net Profit (c - d- e)	$210,000	$282,000	$307,500	$300,000

Calculation of Break-even in units (Ovens) to achieve the target profit of $300,000 will be:

Contribution margin per unit = Selling price per unit - Variable cost per unit = $800 - $500 = $300 per unit

Fixed expense = $270,000

Unit sales for target profit = (Fixed expense + Target profit) / Contribution margin per unit

= ($270,000 + $300,000) / $300 = 1,900 ovens

Therefore the company has to sell 1,900 ovens to achieve a target profit of $300,000.