Question

1. Lexus Industries manufactures four products. The following information is available for each product:

	Product A	Product B	Product C	Product D
Selling price	$20	$26	$28	$15
Variable costs	$12	$10	$14	$5
# of machine hours	4	5	4	3.5

Lexus Industries’ sales are limited by the number of machine hours it has available.

Required:

Provide management with a ranking of the order in which the products should be produced to maximize profit given its limited machine capacity. Show all calculations for full marks.

2. Patio Paradise has been in business for seven years and manufactures tech products. While demand is high, the company has an annual production capacity of 22,000 units.

A summary of operating results for last year is as follows:

Sales (14,000 units @ $970)                     $13,580,000

Variable costs                                                 5,950,000       

Contribution margin                                        7,630,000

Fixed costs                                                     2,750,000

Net operating profit                                      $ 4,880,000

Patio Paradise expects its regular sales to be 16,000 units next year.

The company must now decide which course of action to take.

Option 1

Over the next year, Patio Paradise can use the extra capacity not needed for its expected regular sales to produce 4,000 patio sets which can be sold for $1,180 each, with a variable cost of $400 per drone. This option would result in additional fixed costs of $235,000.

Option 2

A foreign distributor has made a one-time offer to buy a guaranteed 9,000 patio sets at $920 per unit next year. Patio Paradise expects its regular sales to be 16,000 units over the next year. Accepting this offer would result in an additional fixed cost of $170,000 for the year.

1. Assuming Patio Paradise chooses Option 1, calculate the total operating profit for the next year. (3 marks)
2. Assuming Patio Paradise chooses Option 2, calculate the total operating profit for the next year. (3 marks)
3. If Patio Paradise decides to forego both options and just produce the regular 16,000 units, calculate the total operating profit for the next year. (3 marks)
4. From your calculations above, should Patio Paradise select (a), (b) or (c)? (1 mark)

Answer 1

1 Ranking of production for maximum profit Product A Product B Product C Product D Sales price 20 $ 26 $ 28 $ 15 Less : Variable cost $ 12 $ 10 $ 14 $ 5 Contribution 8 $ 16 $ 14 $ 10 Machine hours 5 3.5 2.00 $ 3.20 $ 3.50 $ 2.86 Contribution per machine hours Rank IV II Notes : Since machine hours is the limiting factor the product which has more contribution per machine hours give more profit and ranking is done accordingly.

2 Units 14,000 Variable cost 5,950,000 Variable cost per unit 425 a Option 1 Normal sales Additional sales Total Sales Units 14,000 4,000 18,000 Sales $ 13,580,000 $ 4,720,000 $ 18,300,000 Variable cost $ 5,950,000 $ 1,600,000 $ 7,550,000 Contribution 7,630,000 $ 3,120,000 $ 10,750,000 Fixed cost $ 2,750,000 $ 235,000 $ 2,985,000 Net operating profit $ 4,880,000 $ 2,885,000 $ 7,765,000

b Option 2 Since maximum capacity is 22,000 units, the company can produce only 13,000 units of regular sales Normal sales Additional sales Total Sales Units 13,000 9000 22000 Sales 12,610,000 $ 8,280,000 $ 20,890,000 Variable cost 5,525,000 $ 3,825,000 $ 9,350,000 Contribution $ 7,085,000 $ 4,455,000 $ 11,540,000 Fixed cost 2,750,000 $ 170,000 $ 2,920,000 Net operating profit $ 4,335,000 $ 4,285,000 $ 8,620,000 If it is assumed that production capacity is not a constraining factor, the profit calculation will be as below Normal sales Additional sales Total Sales Units 16,000 9000 25000 Sales $ 15,520,000 $ 8,280,000 $ 23,800,000 Variable cost 6,800,000 $ 3,825,000 $ 10,625,000 Contribution 8,720,000 $ 4,455,000 $ 13,175,000 Fixed cost 2,750,000 $ 170,000 $ 2,920,000 Net operating profit $ 5,970,000 $ 4,285,000 $ 10,255,000

c Option 3 Units $ 16,000 Sales 15,520,000 Variable cost $ 6,800,000 Contribution 8,720,000 Fixed cost $ 2,750,000 Net operating profit 5,970,000 d Since option 2 generates more profit, Option 2 should be accepted