CASE 7.1 CVP AND INCREMENTAL ANALYSIS. Sarah Drogo, president of Storage, Inc., a company that makes a wide variety of storage boxes for home and office use, is thinking about adding a new line of small plastic storage boxes. This would require a new technology. The company currently uses cardboard of various weights that are used in its other products. Since shifting to plastic is a big move for the company, Sarah wants to make sure that all of the financial and nonfinancial implications are understood before she gets under way. She thinks she can sell 3 million units.

Working with Jarrod White, her business analyst, Sarah puts together the following first-pass information on the new boxes. They would retail for $1.99. The company sells to the distribution channel at 50% of retail, so the product would net the company approximately $1 per box. Jarrod estimates that the boxes would cost $0.15 in direct materials, $0.20 in direct labor, $0.05 in packaging materials, and $0.20 in variable machining costs. The cost of the new equipment, insurance, space (new space would be needed for the operation), support activities, and so on are estimated at $500,000 per year. In addition to these simple estimates, Jarrod determines that manufacturing the new box will require an additional person in manufacturing, quality control, and purchasing. Their salaries would be $30,000, $35,000, and $45,000, respectively.

Adding the new line would also stress the packaging area. Jarrod believes there will be a onetime cost of $175,000 to retrofit the packing and shipping area to accommodate the new smaller boxes, which will be packed in cases of 12 for shipment to customers. The company currently bundle-packs its products with a simple strap device. The new containers will require their own cardboard box, which means there will be many new activities in the packaging area. It is likely that to handle the increased work load, the company will need either a new person at a salary of $25,000 a year, or have to pay overtime at $12.50 per hour for 10 hours a week to four existing workers.

The new machines space requirements and noise level will be a challenge. Storage, Inc.s existing machines are relatively quiet, but the high-pressure extrusion process needed for plastic is much noisier. It is also a bit more dangerous because of the high pressure required. Boxes can be damaged during the process, resulting in very sharp edges. Workers staffing the line will need to wear protective clothing and heavy gloves. Since the plant is not air-conditioned, the combination of the heat from the machine and the heavy protective gear could make the job very uncomfortable. Sarah is considering air-conditioning the part of the plant housing the new machine. This would drive the annual costs up from $500,000 to $650,000 a year, with a one-time cost of $75,000 for the air-conditioning units. Since it would be the only air-conditioned part of the plant, Sarah is concerned this will disgruntle the rest of the work force.

Full of questions, Sarah is looking for help to sort out the quantitative and qualitative issues involved in this potential expansion.

REQUIRED:

A. Using as much of the information as possible, do a CVP analysis of the ongoing costs of running the new production line. How much does Sarah need to sell to break even? To make a $250,000 profit before tax? A $250,000 profit after tax with a tax rate of 25%? Do the analysis in two stagesYear 1 results with the nonrecurring expenditures and an ongoing production analysis for Year 2 that is believed to be the steady state for the line.

B. Sarah could buy the new box from an outside vendor in China for $0.80 per box. She would need new storage space to house the 250,000-unit minimum order required. This space would cost $30,000 a year. She would still need the new inspector to maintain quality control and the new shipping and packing capabilities as the order will be shipped in very large quantities bulk- packed. Review the numbers and do an incremental analysis of the make-vs.-buy option Sarah faces.

C. What should Sarah do? Use the numbers to justify your answer.

D. What qualitative issues should concern Sarah? How much impact do you feel these should have on her decision? Why?