Question

Mary Poppins, a friend of yours, has recently set up a small business making curtains. She has supplied you with the following figures, and has asked your advice on a number of issues:

Costs per month	R
Materials	4 100
Labour	5 000
Production overheads	2 000
Selling and distribution overheads	1 000
Administration overheads	500

The above costs are based on producing and selling 1 200 pairs of curtains per month at a selling price of R15 each.

80% of labour costs are fixed, as are 75% of production overheads, 60% of selling and distribution overheads, and 100% of administration overheads. All other costs vary directly with output.

Mary wants to know:

1. How much profit she will make at the proposed production level and selling price?(3)

b)      How many pairs of curtains she needs to sell to break even at this price?     (3)

c)      If sales are slower than expected, by how much can she reduce her selling price in order to maintain the budgeted level of sales without making a loss?                 (4)

d)     Mary estimates her maximum capacity as 1 500 curtains: would it be worthwhile to drop the price in order to increase sales to capacity? If so, by how much?        (5)

e)    If Mary bought another machine, she could increase her production capacity to 2 500 curtains. Repayments on the machine would be R700 per month, and she would need an extra member of staff, costing R1 000 per month. She would also have to pay a bonus to all staff of 50 cents per pair of curtains, over and above their current wages, and variable production overheads would increase by 30 cents per pair of curtains.

         In order to increase sales, she would have to reduce the price: she estimates demand at different price levels to be as follows:

Price	Estimated monthly demand
R14	1 500
R13	2 000
3R12	2 500

        

            What would be the optimum price?                                                                      (10)

Required:

Advise Mary on each of the above points, showing your calculations, explaining both the financial and non-financial implications of each where appropriate.

Answer 1

3)A) Calculation of profit at the proposed production level and selling price

Sales revenue [ 12,00 X 15]		R18,000
Less: Expenditure
Materials	R4,100
Labour	R5,000
Production overheads	R2,000
Selling and distribution overheads	R1,000
Administration overheads	R 500
Total expenditure		R12,600
Profit		R 5,400

3)B) Calculation for fixed cost and variable cost

Nature of costs	Total Fixed costs	Total variable cost
Materials		R 4,100
Labour	R 4,000	R 1,000
Production overheads	R 1,500	R 500
Selling and distribution overheads	R 600	R 400
Administrative overheads	R 500
Total	R 6,600	R 6,000

Variable cost per unit = R 6,000 / 1,200 pair = R 5

Contribution per unit = selling price per unit - variable cost per unit

Contribution per unit = R 15 - R 5 = R 10

Break even sales ( Units) = Fixed cost / Contribution per unit

Break even sales ( units) = R 6,600/ R 10 = 660 units.

3)C) Without making a loss she can reduce the product selling price.

If she, sold 1,200 units of products then total cost incurred on its = Fixed cost + variable cost

Fixed cost = R 6,600 same in every level of production

Variable cost for 1,200 units of production and sells = R 5 X 1,200 = R 6,000

Total cost incurred for 1,200 units of production and sales = R 6,600 + R 6,000 = R 12,600

Revised selling price only to cover the expenditures, and not to suffer any loss = R 12,600 / 1,200 = R 10.50

3)D) Variable cost is proportionate to the number of sales output. So, if she sales 1,500 units, then her contribution per unit margin will be same that is R 10.

Fixed cost will be remain same for producing and selling 1,500 units of products. So, her net profit will be [ 1,500 X R 10] - R 6,000 = R 9,000.

Previously the net profit was R 5,400 for 1,200 units of production and selling of products.

Previously net profit per unit = R 5,400/ 1,200 = R 4.50

Now estimated net profit per unit = R 9,000 / 1,500 = R 6.00

The firm can reduce it's selling price to increase the sales by [ R 6.00 - R 4.50] = R 1.50 per unit .

3)E) Calculation for revised total fixed and variable cost :

Nature of costs	Total fixed cost	Total variable cost per unit
Previously calculated cost for 1,200 units of production	R6,600	R 5.00
Repayment on the machine	R 700
Staff salaries	R1,000
Bonus to staff		R 0.50
Variable production costs		R 0.30
Revised fixed cost =	R7,700
Revised variable cost per unit =		R 5.80

Calculation for optimum price as per the three demand estimates  

	Demand estimate 1	Demand estimate 2	Demand estimate 3
Sales revenue	R 21,000	R 26,000	R 30,000
Less:
Fixed cost	R 7,700	R 7,700	R 7,700
Variable cost @ R 5.80	R 8,700	R 11,600	R 14,500
Total cost	R 16,400	R 19,300	R 22,200
Net profit	R 6,400	R 6,700	R 7,800

The optimum price is R 12 per unit.