Question

(Note: This type of decision is similar to dropping a product line.) Nicholas Company manufactures a fast-bonding glue, normally producing and selling 44,000 litres of the glue each month. This glue, which is known as MJ-7, is used in the wood industry to manufacture plywood. The selling price of MJ-7 is $30 per litre, variable costs are $18 per litre, fixed manufacturing overhead costs in the plant total $253,000 per month, and the fixed selling costs total $338,800 per month. Strikes in the mills that purchase the bulk of the MJ-7 glue have caused Nicholas Company’s sales to temporarily drop to only 11,000 litres per month. Nicholas Company’s management estimates that the strikes will last for two months, after which sales of MJ-7 should return to normal. Due to the current low level of sales, Nicholas Company’s management is thinking about closing down the plant during the strike. If Nicholas Company does close down the plant, fixed manufacturing overhead costs can be reduced by $66,000 per month and fixed selling costs can be reduced by 10%. Start-up costs at the end of the shutdown period would total $7,760. Since Nicholas Company uses lean production methods, no inventories are on hand.

Required:

1-a.	Assuming that the strikes continue for two months, compute the increase or decrease in income from closing the plant.

1-b.	Would you recommend that Nicholas Company close its own plant?
	Yes No

2.	At what level of sales (in litres) for the two-month period should Nicholas Company be indifferent between closing the plant and keeping it open? (Hint: This is a type of break-even analysis, except that the fixed-cost portion of your break-even computation should include only those fixed costs that are relevant (i.e., avoidable) over the two-month period.)

Answer 1

1		Plant Kept Open	Plant Closed		Difference: Net Operating Income Increase or (Decrease)
	Sales (11,000 units × $30 per unit × 2)	$         660,000	$            -		$                     (660,000)
	Variable expenses (11,000 units × $18 per unit × 2)	396,000	-		396,000
	Contribution margin	264,000	-		(264,000)
	Less fixed costs:
	Fixed manufacturing overhead costs ($253,000× 2)	506,000	374,000		132,000
	Fixed selling costs($338,800 × 2)	677,600	609,840	*	67,760
	Total fixed costs	1,183,600	983,840		199,760
	Net operating loss before start-up costs	(919,600)	(983,840)		(64,240)
	Start-up costs	-	(7,760)		(7,760)
	Net operating loss	$        (919,600)	$ (991,600)		$                       (72,000)
	* $338,800 × 90% = $304,920 × 2 = $609,840
	No, plant should not be closed, since it will reduce the Net operating income by $72,000, ans also goodwill will be lost.
2	Nicholas Company will not be affected at a level of 16,000 total units sold over the two-month period. The computations are:
	Cost avoided by closing the plant for two months (see above)	$         199,760
	Less start-up costs	7,760
	Net avoidable costs	$         192,000
	Net avoidable cost ÷ C.M per unit
	$192,000 ÷ 12 = 16,000 units