Question 2

Cost function; breakeven; targeted profit; uncertainties and bias; interpretation

Joe Davies is thinking about starting a company to produce carved wooden clocks. He loves makingthe 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 wouldhave enoughmoney to liveon. 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 clock.

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 restof the year. However,he isfairly 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 himselfthemonthly salary of $3000, and earn at least $4000 more than that per month. (Ignore income taxes.)

Required

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

(i)List all of the costs described and indicate whether each cost is (1) a relevant fixed cost, (2) a relevant variable cost or (3) not relevant to Joe's decision.

(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 CVP calculations:

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

(ii)Identify possible costs for Joe's business that he has not identified. List as many additional types of cost as you can.

(iii)Explain why Joe cannot know for sure how many clocks he will selleach 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 interpretation of the breakeven analysis results.

(e)Use the information you learned from the preceding analyses to write a memo to Joe with your recommendations. Attach to the memo a schedule showing relevant information. As appropriate, refer to the schedule in the memo.