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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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