Question

XYZ Trilby Ltd is a company that specializes in online Hats retailing. The company’s unique selling point is its creative and quirky designs. Anyone in the world can submit a design and if it is popular enough (i.e., gets enough votes) XYZ Trilby Ltd will produce and market the Trilby Hats on its well-known website. The designer of each Trilby Hat is guaranteed a fixed percentage of each sale in return for their successful design work. Each Trilby Hats sells for $30 each. Designers get $5 from each sale of each Trilby Hat that they have designed. So popular is the site, the company’s most successful Hats designers are able to make a living just by creating new designs for Trilby Hats. The company expects to produce and sell 100,000 Hats this year, although there is a total production capacity of 110 000 in the current factory setup. Fixed costs are $400,000 per year. The direct costs of production are $24.50 per Hat (this includes $5 paid to the designers, the purchase of ‘unfinished’ Hats from a Chinese supplier, factory floor staff, dies, paints, postage, etc.). Victoria, the Operations Manager is examining a proposal put forward by the company’s CEO to buy in a new automated screen printing machine that links with new design software. This would enable a new design and manufacturing process capable of producing very large runs of custom designs. The quality would be very much improved. Production capacity could be increased to 200,000 Hats per year. There are very large overheads associated with the purchase of the new machine and IT system, namely the high cost of financing these purchases. Total fixed costs would double to $800,000 per year. Savings would be made by reducing the number of factory workers directly employed in the manufacturing process. Some of these savings would then be used to purchase in higher priced and higher quality unfinished Hats. Direct costs of production would decrease to $17.50 per Hats. Research from the marketing department indicates that higher quality Hats, higher quality designs and a price reduction to $25 would increase the demand for Trilby Hats by 50 per cent to 150,000 Hats per year.

1. Construct a break-even graph to represent the current data, identifying the break-even level of production and the safety margin. [5 Marks]
2. Calculate the break-even level of output and profit associated with the new manufacturing system. [(2 +2) Marks]
3. Based on monetary and non-monetary factors, advise the firm, as to whether it should remain as it is or to adopt the new design and manufacturing system. [6 Marks]

Answer 1

a) Break even level of Production in current situation = 72727 hats

Margin of safety =$ 818190

Explanation-----

BEP = total fixed cost (TFC)/ contribution per unit ( CPU)

CPU= selling price per unit- variable cost p/u

BEP=TFC/CPU=400000/30-24•50=72727 hats

Margin of safety ($)= Actual sales -- break even sales

MOS= 100000×30 --. 72727×30=$818190

b) Break even level of output under new system = 106667 hats

profit =$325000

Explanation-----

TFC=$800000,CPU=25--17•5=$7•5 per hat

Break even point ( units)= 800000/7•5=106667 hats

# profit = TR--TC

TR=150000×25=$3750000

TC=800000+150000×17•50=$3425000

Profit= 3750000--3425000=$325000

C) The firm is advised to adopt the new designing and manufacturing system.

Explanation-----

Monetary factors----

✓More profits as compared to current system as current system gives Profit worth $150000

[ 100000×30 -- {400000-(100000×24•50)}]=$150000

Profit under new system =$325000

✓More sales volume -- current volume = 100000, new volume =150000

Non monetory factors-----

✓ higher quality hats

✓ lower prices

✓ Ability to meet jigher demand with more capacity.