Tannert Company manufactures furniture. One of its product lines is an economy line

kitchen table. During the last year, Tannert produced and sold 100,000 units for $100 per

unit. Sales of the table are on a bid basis, but Tannert has always been able to win sufficient

bids using the $100 price. This year, however, Tannert was losing more than its share of

bids. Concerned, Larry Franklin, Owner and President of the company, called a meeting of

his Executive Committee (Megan Johnson, Marketing Manager; Fred Davis, Quality

Manager; Kevin Jones, Production Manager; and Helen Jackson, Financial Controller).

Larry: I don't understand why we're losing bids. Megan, do you have an explanation?

Megan: Yes, as a matter of fact. Two competitors have lowered their price to $92 per unit.

That's too big a difference for most of our buyers to switch to other suppliers. If we want to

keep selling our 100,000 units per year, we will need to lower our price to $92. Otherwise,

our sales will drop to between 20,000 and 25,000 per year.

Helen: The unit contribution margin on the table is $10. Lowering the price to $92 will cost

us $8 per unit. Based on a sales volume of 100,000, we'd make $200,000 in contribution

margin. If we keep the price at $100, our contribution margin would between $200,000 and

$250,000. If we have to lose, let's just take the lower market share. It's better than lowering

our prices.

Megan: Perhaps. But the same thing could happen to some of our other product lines. My

sources tell me that these two companies are on the tail end of a major quality improvement

programme - one that allows them to make significant savings. We need to rethink our whole

competitive strategy - at least if we want to stay in business. Ideally, we should match the

price reduction and work to reduce the costs to recapture the lost contribution margin.

Fred: I think I have something to offer. We are about to embark on a new quality

improvement programme of our own. I have brought the following estimates of the current

quality costs for this economy line. As you can see in the overhead costs, these costs run

about 16 percent of current sales. That's excessive, and we believe that they can be

reduced to about 4 percent of sales over time.

Scrap $ 700,000

Rework $ 300,000

Rejects (sold as seconds to discount houses) $ 250,000

Returns (due to poor workmanship) $ 350,000

$1,600,000

Larry: This sounds good. Fred, how long will it take you to achieve this reduction?

Fred: Because all these costs vary with sales level, I'll express their reduction rate in those

terms. Our best guess is that we can reduce these costs by about 1 percent of sales per

quarter. So it should take about 12 quarters, or three years, to achieve the full benefit. Keep

in mind that this is with an improvement in quality.

Megan: This offers us some hope. If we meet the price immediately, we can maintain our

market share. Furthermore, if we can ever reach the point of reducing the price beyond the

$92 level, then we can increase our market share. I estimate that we can increase sales by

about 10,000 units for every $1 of price reduction beyond the $92 level. Kevin, how much

extra capacity for this line do we have?

Kevin: We can handle an extra 30,000 or 40,000 tables per year.

Answer the following questions:

1. Assume that Tannert immediately reduces the bid price to $92. How long will it be before

the unit contribution margin is restored to $10, assuming that quality costs are reduced

as expected and sales are maintained at 100,000 units per year (25,000 units per

quarter)?

2. Assume that Tannert holds the price at $92 until the 4 percent target is achieved. At this

new level of quality costs, should the price be reduced? If so, by how much should the

price be reduced, and what is the increase in contribution margin? Assume that the price

can be reduced only in $1 increments.

3. Assume that Tannert immediately reduces the price to $92 and begins the quality

improvement programme. Now, suppose that Tannert does not wait until the end of the

three-year period before reducing prices. Instead, prices will be reduced when profitable

to do so. Assume that prices can be reduced only by $1 increments. Identify when the

first future price change should occur (if any).

4. Discuss the differences in viewpoints concerning the decision to decrease prices and the

short-run contribution margin analysis done by Helen, the controller. Did quality cost

information play an important role in the strategic decision making illustrated by the

problem?

All calculations have to be explained.