Question

Major Mills is a large manufacturer of breakfast cereal. One of its most popular products is Sugar-Bombs, which sells at wholesale for $55/case.

The cost to produce is $42.20 per case, as follows: Ingredients, $8.70; Packaging, $4.10; Direct Labor, $3.40; Overhead, $26 (20% variable).

A large grocery retailer has approached Major Mills with a proposal to create a house-brand version of Sugar-Bombs.

The retailer offers to purchase 10,000 cases per month of the house brand for one year, after which the contract could be renewed. The retailer will purchase the house brand for $33/case.

A slight change in the recipe would reduce ingredients cost by 30 cents per case. Packaging cost would increase by 12 cents per case because of a new ink required.

There would be an initial annual setup cost of $18,000. Because Major Mills has excess capacity of only 9,000 cases per month on the production line, they would lose 1,000 cases per month of sales of Sugar-Bombs.

a) Would accepting the retailer's offer be profitable for Major Mills?

b) What other factors should Major Mills consider in deciding whether to accept this offer?

Answer 1

Solution

Major Mills

1. Determination of the profitability of accepting the retailer’s offer for Major Mills:

Computations:

Original Contribution margin per case –

Selling price per case = $55

Variable cost per case –

Ingredients            $8.70

Packaging             $4.10

Direct labor           $3.10

Overhead              $5.20 ($26 x 20%)

Total variable cost $21.10

Contribution margin = $55 - $21.10 = $33.90 per case

Contribution margin for the price offered by retailer –

Offer price = $33 per case

Variable cost –

Ingredients            $8.40          (less by $0.30 per case)

Direct labor           $3.10

Packaging             $4.22 (increase by $0.12)

Overhead              $5.20

Total                     $20.92

Contribution margin = $33 - $20.92 = $12.08 per case                     

Contribution margin for 1 year for 10,000 cases = $12.08 x 10,000 x 12 months = $1,449,600

Less: initial set up cost    ($18,000)

Less: original contribution loss on 1,000 cases for 12 months = $33.90 x 1,000 x 12 = ($406,800)

Annual Profitability of accepting retailer’s offer = $1,449,600 – ($18,000) – ($406,800) = $1,024,800

Increase in Monthly profitability = $1,024,800/12 = $85,400

Increase in monthly profitability per case = $85,400/10,000 = $8.54 per case

Yes, Acceptance of retailer’s offer is profitable to Major Mills, as the offer would increase the company’s monthly profitability by $85,400.

Note: fixed overhead is not relevant in determining the incremental profitability, as it is a period cost.

2. Other factors to consider in accepting the short-term offer –

1. Availability of excess capacity to meet the order. Also, impact of accepting the offer on planned sales or existing customers.
2. Incremental profit (excess of incremental revenue over incremental costs)

For the situation above, $18,000 is also an incremental cost as it would be incurred exclusively to fulfill the order.

3. Product Quality concerns.