Question
Sub Optima Corporation has been suffering from sales demand at less than full utilization of its capacity. It has two product lines, A and B.
Sub Optima Corporation has been suffering from sales demand at less than full utilization of its capacity. It has two product lines, A and B. Product line A has been weak for several years. Sub Optima has tried to maintain its pricing at $110 a unit, but has steadily lost sales volume until it sells about 100,000 units less than it did five years ago. Last year, the company sold 200,000 more units of product B, but a contract for that many units per year ran out when Sub Optima bid its usual price of $200 a unit. With that contract, product line B had operated at approximately full capacity. However, a competitor, faced with idle capacity, substantially undercut that price. No other Sub Optima customer purchases such a large volume of either product. Below are cost and revenue information and the budget for the current year. Sub Optima is under considerable pressure to turn the projected pre-tax loss into a pre-tax profit.
Budget Information | ||
Product A | Product B | |
Sales volume in units | 500,000 | 300,000 |
Average sales price per unit | $110 | $200 |
Unit cost factors: | ||
Direct material cost | $25 | $40 |
Direct labor | $20 | $40 |
Machine hours per unit | 10 | 15 |
Overhead: | ||
Variable--per DM$ | 0.30 | 0.40 |
Variable--per DL$ | 0.50 | 0.40 |
Variable--per machine hour | $1.00 | $1.50 |
Fixed--per machine hour | $4.00 | $4.00 |
Budget | |||
Product A | Product B | Totals | |
Total revenue | $55,000,000 | $60,000,000 | $115,000,000 |
Product costs: | |||
Direct material cost | 12,500,000 | 12,000,000 | 24,500,000 |
Direct labor | 10,000,000 | 12,000,000 | 22,000,000 |
Overhead: | |||
Variable--based on DM$ | 3,750,000 | 4,800,000 | 8,550,000 |
Variable--based on DL$ | 5,000,000 | 4,800,000 | 9,800,000 |
Variable--based on machine hours | 5,000,000 | 6,750,000 | 11,750,000 |
Fixed | 20,000,000 | 18,000,000 | 38,000,000 |
Total product cost | 56,250,000 | 58,350,000 | 114,600,000 |
Gross margin | -1,250,000 | 1,650,000 | 400,000 |
Selling and administrative costs | 2,500,000 | ||
Income before taxes | -2,100,000 | ||
Margin on sales revenue | -1.83% |
a. Management is looking at the possibility of dropping Product A since it is the major cause of the projected loss. However, the VP-Sales has counter proposed dropping the price of A from $110 to $105. She believes that the company can sell an additional 100,000 units with such a drop in price and that competitors will not want to follow the price decrease because they will want to keep up their contribution margins per unit. There are several competitors, so each will lose only a fraction of Sub Optimas increased sales. However, the CEO is worried that if the competitors do retaliate with similar price cuts, Sub Optima will be stuck with a lower price and the same 500,000 unit volume. If the VPs scenario proves to be true, is it worth pursuing? Calculate the consequences if the CEOs worst fear comes true. On what factors should this decision hinge?
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