Question

AJ Ventures Ltd is a company engaged in the manufacture of water bottles which are bought mainly for sporting activities. Present sales are direct to retailers, but in recent years there has been a steady decline in output because of increasing foreign competition. In the last business year (2018) the company produced its lowest profit in ten (10) years. The forecast for 2019 indicates that the present deterioration in profits is likely to continue.

The company considers that a profit of $80,000 should be achieved to provide an adequate return on capital. The managing director has asked that a review be made of the present pricing and marketing policies. The marketing director has completed this review, and passes the proposals on to you for evaluation and recommendation, together with the Income statement for the year ending December 31, 2018 (see below).

AJ Ventures limited.

INCOME STATEMENT

For the Year Ending, December 31, 2018

Sales Revenue (100,000 Bottles at $10)			$1,000,000
Cost of goods sold
Direct Materials	$100,000
Direct Labour	350,000
Variable Manufacturing overheads	60,000
Fixed Manufacturing overheads	220,000
		$730,000
Administrative Overhead		140,000
Selling and Distribution Overhead
Sales commission (2% of sales)	20,000
Delivery cost (variable per unit sold)	50,000
Fixed costs	40,000
		110,000
			$980,000
Income			$20,000

The information to be submitted to the managing director includes the following three proposals:

(i) To proceed on the basis of analyses of market research studies that indicate that the demand for the bottles is such that a 10% reduction in selling price would increase demand by 40 %.

(ii) To proceed with an enquiry that the marketing director has had from a mail order company about the possibility of purchasing 50,000 bottles annually if the selling price is right. The mail order company would transport the bottles from AJ ventures to its own warehouse, and no sales commission would be paid on these sales by AJ ventures. However, if an acceptable price can be negotiated, AJ ventures would be expected to contribute $60,000 per annum towards the cost of producing the mail order catalogue. It would also be necessary for AJ ventures to provide special additional packaging at a cost of $0.50 per bottle. The marketing director considers that in 2019 the sales from existing business would remain unchanged at 100,000 bottles, based on a selling price of $10 if the mail order contract is undertaken.

(iii) To proceed on the basis of a view held by the marketing director that a 10% price reduction, together with a national advertising campaign costing $30,000, may increase sales to the maximum capacity of 160,000 bottles.

Required

a. The calculation of break-even sales value based on the 2018 results.

b. A financial evaluation of proposal (i)

c. A calculation (under proposal (i)) of the number of bottles AJ ventures would need to sell at $9 each to earn the target profit of $80.000.

d. A calculation of the minimum prices that would have to be quoted to the mail order company to

1.              I.    ensure that AJ ventures would at least break even on the mail order contract

1.             II.    ensure that the same overall profit is earned as in proposal (i) from the mail order contract.

1.           III.    Ensure that the overall target profit is earned, from the mail order contract.

e. A financial evaluation of proposal (iii)

Answer 1

a. The calculation of break-even sales value based on the 2018 results.

Total variable cost=$(100,000+350,000+60,000+20,000+50,000)=$580,000

Contribution margin ratio=$(1000000-580000)/1000000*100=42%

Now,Breakeven sales values(as per 2018 results)=Total fixed cost/Contribution margin ratio

=$(220,000+140,000+40,000)/0.42=$952380.95

b. A financial evaluation of proposal (i)

		$
Sales(140000 at $9)		1,260,000
Variable cost
Direct materials	140,000
Direct labour	490,000
Variable manufacturing overhead	84,000
Sales commission	25,200
Delivery cost	70,000	809,200
Contribution margin		450,800
Less:Total fixed cost		400,000
Income from operations		50,800

c. A calculation (under proposal (i)) of the number of bottles AJ ventures would need to sell at $9 each to earn the target profit of $80.000.

Variable cost per unit under proposal(i)=809,200/140,000=$5.78

Contribution margin per unit=$9.00-$5.78=$3.22

Number of bottles needed to be sold to earn the target profit of $80,000=$(400,000+80,000)/$3.22=149068.32 bottles

d. A calculation of the minimum prices that would have to be quoted to the mail order company to

1)ensure that AJ ventures would at least break even on the mail order contract

Total variable cost per unit on the mail order contract

Direct materials	$1.00
Direct labour	$3.50
Variable manufacturing overhead	0.60
Special packaging	0.50
Total	$5.60

There is a fixed cost of $60000 per annum for the mail order contract

Let the contribution margin per unit be C

A the break even,C=60000/50000=$1.20

MInimum selling price=unit variable cost+unit contribution margin=5.60+1.20=$6.80

II.    ensure that the same overall profit is earned as in proposal (i) from the mail order contract.

Unit contribution margin=$(60000+20000)/50000=$1.60

Minimum selling price=5.60+1.60=$7.20

III.    Ensure that the overall target profit is earned, from the mail order contract.

Minimum selling price=$(60000+60000)/50000+5.60=$8.00

e. A financial evaluation of proposal (iii)

	$	$
Sales(160000*$9)		1,440,000
Variable costs
Direct materials	160,000
Direct labor	560,000
Variable manufacturing overhead	96,000
Sales commission	28,800
Delivery cost	80,000	924,800
Contribution margin		515,200
Fixed costs(400000+30000)		430,000
Income from operations		85,200