Question

Calculate the contribution margin (selling price minus variable costs) and gross margin

(selling price minus all manufacturing costs) per gallon for each type of paint and total firm-wide

profit under each of the following scenarios:

Scenario A Current production, including the Virginia contract

Scenario B Without either the Virginia contract or the promotion to expand sales of commercial

paint

Scenario C Without the Virginia contract but assuming the promotional campaign is undertaken

and sales of commercial paint do in fact double

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What insight is provided by a comparison of Scenarios A and B? What insight is provided by

a comparison of Scenarios B and C?

Traffic Paint

Currently, Wellesley has the traffic paint contracts for the states of Pennsylvania, North Carolina,

Delaware, and Virginia. Of last year’s total production of 380,000 gallons, 90% was traffic

paint. Of this amount, 88,000 gallons were for the Virginia contract. Each state has unique specifications

for color, thickness, texture, drying time, and other characteristics of the paint. For example,

paint sold to Pennsylvania must withstand heavy use of salt on roads during the winter.

Paint for North Carolina highways must tolerate extended periods of intense heat during summer

months.

The process of bidding on a traffic paint contract begins with a road test under the supervision

of the National Association of Highway Paints (NAHP), an independent organization supported

by state funds. NAHP designates a certain stretch of highway to serve as the road test site.

Any paint manufacturer may apply stripes of their paint at the test site. NAHP monitors the test

site and reports the results to the state highway department. State personnel review the reports

and invite the manufacturers of the best-performing paints to submit bids. The firm that submits

the lowest bid wins the contract.

Contracts, which normally cover a five-year period, specify only the price per gallon and

quality requirements such as drying time and road-life. The timing of deliveries is determined

later based on state work schedules and weather constraints. Demand is highly seasonal, as states

do most of their highway painting in June, July, and August. The total amount of paint a state will

order is not determined until spring, when the states know how much of their highway budget

remains after winter snow removal costs have been paid.

After the paint is produced, the state must test the paint before approving it for shipment. A

sample is sent to the state laboratory, which may take up to two months to perform the testing. In

the meantime, Wellesley must store all the manufactured paint in its warehouse. At times, the

warehouse has been filled to capacity, and drums of paint are stored in the aisles, production

areas, and any available inch of space.

Due to the high cost of shipping paint, most paint producers can be competitive on price

only in locations fairly close to their production facilities. Accordingly, Wellesley has enjoyed an

advantage in bidding on contracts in the eastern states close to Virginia. However, one of their

biggest competitors, Heron Paint Company of Houston, Texas, is building a new plant in North

Carolina. With lower costs due to their efficient new facility and their proximity, Heron will become

a major competitive threat.

Commercial Paint

Wellesley’s commercial paint line includes interior and exterior house paints in a wide range

of colors formulated to approximate authentic colonial colors. Because of the historical association,

the line has been well received in Virginia. Most of these paints are sold through paint and

hardware stores as the stores’ second or third line of paint. The large national firms such as Benjamin

Moore or Sherwin Williams provide extensive services to paint retailers such as computer

ized color matching equipment. Partly because they lack the resources to provide such amenities

and partly because they have always considered the commercial paint a sideline, Wellesley has

never tried to market their commercial line aggressively.

Mrs. W. is worried about the future of the company. The firm’s strategic goal is to provide a

quality product at the lowest possible cost and in a timely fashion. After absorbing the shock of

losing the Virginia contract, Mrs. W. wondered whether the firm should consider increasing production

of commercial paints to lessen the company’s dependence on traffic paint contracts. Her

son, who manages the day-to-day operation of the firm, believes they can double their sales of

commercial paint if they undertake a promotional campaign estimated to cost $15,000. The average

price of traffic paint sold last year was $9 per gallon. For commercial paint, the average price

was $11.

Cost Data

Charlie Oliver has assembled the following data to evaluate the financial performance of the

two lines of paint. The primary raw material used in paint production is latex. The list price for

latex is $13.50 per pound. If the firm uses more than 150,000 pounds annually they qualify for a

10% discount; 450 pounds of latex are needed to produce 1,000 gallons of traffic paint. Commercial

paint requires 325 pounds of latex per 1,000 gallons of paint. In addition to the cost of the

latex, other variable costs are as shown below.

Raw materials cost per gallon of paint: Traffic Commercial

Camelcarb (limestone) 0.38 0.54

Silica 0.37 0.52

Pigment 0.12 0.38

Other ingredients 0.06 0.03

Direct labor cost per gallon 0.46 0.85

Freight cost per gallon 0.78 0.43

Last year, overhead costs attributable to the traffic paint totaled $85,000, including an estimated

$25,000 of costs directly associated with the Virginia contract. Overhead costs attributable

to the commercial paint are $13,000. Other manufacturing overhead costs total $110,000. Charlie

estimates that $9,000 of this amount is inventory handling costs that will be avoided due to the

loss of the Virginia contract. Both the remaining manufacturing overhead and the general and

administrative costs of $140,000 are allocated equally to all gallons of paint produced.

Answer 1

Scenario A
	Traffic	Commercial	Total
Production	342,000	38,000	380,000
Latex needed to produce 1000 gallons of paint	450	325
Latex needed	153,900	12,350	166,250
	(342000/1000*450)	(38000/1000*325)
Cost per pound of latex (10% discount applicable)	12.15	12.15
Latex needed per gallon	0.45	0.33
Cost per gallon of paint	5.47	3.95
Camel carb	0.38	0.54
Silica	0.37	0.52
Pigment	0.12	0.38
Other Ingredients	0.06	0.03
Direct Labor per gallon	0.46	0.85
Freight cost per gallon	0.78	0.43
Total cost per gallon	7.64	6.70
Total Variable cost	2,612,025	254,553	2,866,578
Sales per gallon	9.00	11.00
Sales	3,078,000	418,000	3,496,000
Variable cost	2,612,025	254,553	2,866,578
Contribution	465,975	163,448	629,423
Contribution per gallon	1.36	4.30	1.66
Overhead cost	85,000	13,000	98,000
Other Manufacturing cost for virginia contract	9,000	-	9,000
Other Manufacturing allocated	90,900	10,100	101,000
Gross Margin	281,075	140,348	421,423
Gross Margin per gallon	0.82	3.69	1.11
General and Administrative Costs	126,000	14,000	140,000
Net Income	155,075	126,348	281,423

Scenario B
	Traffic	Commercial	Total
Production	254,000	38,000	292,000
Latex needed to produce 1000 gallons of paint	450	325
Latex needed	114,300	12,350	126,650
	(254000/1000*450)	(38000/1000*325)
Cost per pound of latex	13.50	13.50
Latex needed per gallon	0.45	0.33
Cost per gallon of paint	6.08	4.39
Camel carb	0.38	0.54
Silica	0.37	0.52
Pigment	0.12	0.38
Other Ingredients	0.06	0.03
Direct Labor per gallon	0.46	0.85
Freight cost per gallon	0.78	0.43
Total cost per gallon	8.25	7.14
Total Variable cost	2,094,230	271,225	2,365,455
Sales per gallon	9.00	11.00
Sales	2,286,000	418,000	2,704,000
Variable cost	2,094,230	271,225	2,365,455
Contribution	191,770	146,775	338,545
Contribution per gallon	0.76	3.86	1.16
Overhead cost	60,000	13,000	73,000
Other Manufacturing cost for virginia contract	-	-	-
Other Manufacturing allocated	87,856	13,144	101,000
Gross Margin	43,914	120,631	164,545
Gross Margin per gallon	0.17	3.17	0.56
General and Administrative Costs	121,781	18,219	140,000
Net Income	-                           77,867	102,412	24,545

Scenario C
	Traffic	Commercial	Total
Production	254,000	76,000	330,000
Latex needed to produce 1000 gallons of paint	450	325
Latex needed	114,300	24,700	139,000
	(254000/1000*450)	(76000/1000*325)
Cost per pound of latex	13.50	13.50
Latex needed per gallon	0.45	0.33
Cost per gallon of paint	6.08	4.39
Camel carb	0.38	0.54
Silica	0.37	0.52
Pigment	0.12	0.38
Other Ingredients	0.06	0.03
Direct Labor per gallon	0.46	0.85
Freight cost per gallon	0.78	0.43
Total cost per gallon	8.25	7.14
Total Variable cost	2,094,230	542,450	2,636,680
Sales per gallon	9.00	11.00
Sales	2,286,000	836,000	3,122,000
Variable cost	2,094,230	542,450	2,636,680
Contribution	191,770	293,550	485,320
Contribution per gallon	0.76	3.86	1.47
Overhead cost	60,000	13,000	73,000
Other Manufacturing cost for virginia contract	-	-	-
Other Manufacturing allocated	77,739	23,261	101,000
Gross Margin	54,031	257,289	311,320
Gross Margin per gallon	0.21	3.39	0.94
General and Administrative Costs	107,758	32,242	140,000
Prmotional Campaign cost	-	15000	15,000
Net Income	-                           53,727	210,047	171,320

Sceanrio A & B comparison

Due to less use of latex, since the Virginia contract is lost, the firm lost the discount on latex. this added to cost of per gallon of latex. Without the virginia contract, the traffic paint division is operating at a loss. Commercial paint department is clearly more profitable than traffic paint. However the volume of traffic paint sale is more than commercial paint. For traffic paint depatmet to operate at aprofit they need to increase the sales. this will make them elgible for discount on latex.

Scenarios B& C

Even though the sale of commercial paint has doubled, the firm is still not eligible for latex discount. Theres is no change in contriibution per unit fromScenaio B to C. There was not enough increase in sales units to bring down the per unit variable cost.