Question

Luke Corporation produces a variety of products, each within their own division. Last year, the managers at Luke developed and began marketing a new chewing gum, Bubbs, to sell in vending machines. The product, which sells for $5.95 per case, has not had the market success that managers expected and the company is considering dropping Bubbs.

The product-line income statement for the past 12 months follows:

Revenue				$	14,703,150
Costs
Manufacturing costs	$	14,447,395
Allocated corporate costs (@5%)		735,158			15,182,553
Product-line margin				$	(479,403	)
Allowance for tax (@20%)					95,880
Product-line profit (loss)				$	(383,523	)

All products at Luke receive an allocation of corporate overhead costs, which is computed as 5 percent of product revenue. The 5 percent rate is computed based on the most recent year’s corporate cost as a percentage of revenue. Data on corporate costs and revenues for the past two years follow:

	Corporate Revenue		Corporate Overhead Costs
Most recent year	$	120,750,000	$	6,037,500
Previous year		77,600,000		5,079,570

Roy O. Andre, the product manager for Bubbs, is concerned about whether the product will be dropped by the company and has employed you as a financial consultant to help with some analysis. In addition to the information given, Mr. Andre provides you with the following data on product costs for Bubbs:

Month	Cases	Production Costs
1	221,000	$1,162,840
2	224,200	1,184,340
3	221,900	1,192,993
4	242,000	1,208,535
5	249,950	1,210,839
6	251,000	1,231,685
7	227,250	1,206,711
8	254,200	1,249,786
9	245,800	1,248,238
10	259,650	1,260,337
11	257,200	1,264,772
12	266,200	1,295,463

Required:

a. Bunk Stores has requested a quote for a special order of Bubbs. This order would not be subject to any corporate allocation (and would not affect corporate costs). What is the minimum price Mr. Andre can offer Bunk without reducing profit any further?

b. How many cases of Bubbs does Luke have to sell in order to break even on the product?

c. Suppose Luke has a requirement that all products have to earn 5 percent of sales (after tax and corporate allocations) or they will be dropped. How many cases of Bubbs does Mr. Andre need to sell to avoid seeing Bubbs dropped?

d. Assume all costs and prices will be the same in the next year. If Luke drops Bubbs, how much will Luke’s profits increase or decrease? Assume that fixed production costs can be avoided if Bubbs is dropped.

Answer 1

a)
SUMMARY OUTPUT
Regression Statistics
Multiple R	0.917094143
R Square	0.841061667
Adjusted R Square	0.825167834
Standard Error	16105.24144
Observations	12
ANOVA
	df	SS	MS	F	Significance F
Regression	1	1.3726E+10	1.3726E+10	52.917484	2.6804E-05
Residual	10	2593788020	259378802
Total	11	1.6319E+10
	Coefficients	Standard Error	t Stat	P-value	Lower 95%	Upper 95%	Lower 95.0%	Upper 95.0%
Intercept	686868.9068	74310.6428	9.2432104	3.2539E-06	521294.476	852443.337	521294.476	852443.337
X Variable 1	2.216895961	0.30475141	7.27444046	2.6804E-05	1.53786751	2.89592441	1.53786751	2.89592441
The minimum price Mr. Andre can offer Bunk without reducing profit any further is equal to variable cost per unit	$            2.22
b)
High-low method:
Variable cost estimate = (Cost at highest activity – Cost at lowest activity)/(Highest activity – Lowest activity)
	Corporate Revenue	Corporate Overhead Costs
Most recent year	120,750,000	6,037,500
Previous year	77,600,000	5,079,570
Difference	43,150,000	957,930
Variable cost corporate estimate = 957,930/$43,150,000	2.22%	of revenue
Let Q be number of cases sold
Profit = Revenues - Variable Product Cost - Variable Corporate costs - Fixed Production Costs
Profit = $5.95 x Q - $2.22 x Q - ($5.95 Q x 2.22%) - $686868.91
Break Even Point (Q) = $686868.91/ $3.60	190,743.19	cases
c)
Profit = $5.95 x Q - $2.22 x Q - ($5.95 Q x 5%) - $686868.91
Break Even Point (Q) = $686868.91/ $3.44	199,926.68	cases
d)
Lost Revenue	-14,703,150
Product Cost Avoided	14,447,395
Loss Before corporate overhead savings	-255,755
Allocated corporate costs (2.22% x 14703150)	326,410
Increase profits before Tax	70,655
Allowance for tax (@20%)	14,131
Increased  Profits	56,524