Question

2. Blue Nile's Medical Equipment Company manufactures hospital beds. Its most popular model, Deluxe, sells for $5,000. It has variable costs totaling $2,800 and fixed costs of $1,000 per unit, based on an average production run of 5,000 units. It normally has four production runs a year, with $400,000 in setup costs each time. Plant capacity can handle up to six runs a year for a total of 30,000 beds.

A competitor is introducing a new hospital bed similar to Deluxe that will sell for $4,000. Management believes it must lower the price to compete. Marketing believes that the new price will increase sales by 25% a year. The plant manager thinks that production can increase by 25% with the same level of fixed costs. The company currently sells all the Deluxe beds it can produce.

Required:

a.   What is the annual operating income from Deluxe at the current price of $5,000?

b.   What is the annual operating income from Deluxe if the price is reduced to $4,000 and sales in units increase by 25%?

c.   What is the target cost per unit for the new price if target operating income is 20% of sales?

Answer 1

Answer:

a. Annual operating income from Deluxe at the current price of $5,000

Sales $100,000,000

(5,000 units4 production runs in a year$5,000)

Less: Costs

Variable Costs $56,000,000

  (5,000 units4 production runs in a year$2,800)

Fixed Costs $20,000,000

  (5,000 units4 production runs in a year$1,000)

Set up costs $1,600,000

($400,0004 production runs in a year)

Total Costs 77,600,000

Annual Operating income (Sales - total costs) 22,400,000

b. Annual operating income from Deluxe if the price is reduced to $4,000 and sales in units increase by 25%

Current Sales (5,000 units4) =20,000 units

Increased sales (20,000 units+20,00025%) = 25,000 units

Sales $100,000,000

(25,000 units$4,000)

Less: Costs

Variable Costs $70,000,000

  (25,000 units$2,800)

Fixed Costs $20,000,000

  (Same as part(a))

Set up costs $2,000,000

($400,0005 production runs in a year)

Total Costs $92,000,000

Annual Operating income (Sales - total costs) $8,000,000

C. Target cost per unit for the new price if target operating income is 20% of sales

New selling price $4,000

Target Profit |(20% of sales) $800

Target cost per unit (4,000-800) = $3,200