Question

In 2009, David Tucker quit his job at a large beer company to start his own brewery, Tempe Microbrewery (TM). His family supported his decision and invested in the business along with David. TM began operations on January 10, 2010 and now produces four labels of specialty beers (Saguaro pale Ale, Bisbee Bock, Ocotillo Amber Pilsner, and Sedona Stout).  

In much of the United Sates (including Arizona), beer is sold in a “three-tier” system. Under this system, beer is manufactured by producers, sold to distributors, who then sell to retailers (such as liquor stores, drug stores, and grocery stores). David employs two salespeople who received a fixed monthly salary, plus an 8 percent commission. All beer is sold to beer distributors (primarily in the Southwestern United States) in cases of 24 bottles. Product sales and cost information for 2013 are shown in Exhibit 1 with additional information in Exhibit 2. David rents a facility that is used to make the beer, a refrigeration area to store the beer, and a small office area. TM brewery has five machines with 9,300 total machine hours available per year to produce beer (assuming TM remains on one shift with some normal maintenance, breaks, etc.). While there is an empty space in the facility that could be used to expand the beer operations, the company would need to purchase an additional grain hopper and brew house for about $100,000 (the current water system and process control system could be expanded to handle the new machine). As discussed in Appendix A, beers are aged in a refrigeration area prior to sale. The current refrigeration unit allows for different temperatures in different areas of the unit and the unit is usually running about 80 percent full. Keeping the refrigeration unit somewhat full helps reduce refrigeration costs. Additionally, since the company is so new, sales have been growing but erratic (from 2010 to 2011, sales growth was over 45 percent; however, from 2012 to 2013, sales growth was only 12 percent). Thus keeping more beer on hand allows the company to meet the erratic demand without loss of sales.

David has not taken a salary since the business started. While the business has been generating a small profit, David has been reinvesting the earnings in the business. He wants to grow the business to generate more profit for his family and himself. David has been considering increasing the price on Sedona Stout from $26.50 per case to $29.00 per case. He thinks that, with this price increase, unit sales will decrease from 4,184 cases to 3,750 cases per year. However, this would only reduce total annual Stout revenues to $108,750 from $110,876. Alternatively, David could drop the price of Sedona Stout to $25 per case. This is much closer to the Bock price as well as the Pilsner. Based on his market research, he thinks that this will result in Stout sales increasing to 4,700 cases per year. He is leaning toward this alternative as this will increase Stout revenues from $110,876 to $117,500 per year.

While the company has some cash on hand, neither the company nor David’s family have another $100,000 to invest in the business right now for a new grain hopper and brew house. Since the business is new and has been showing only small profits, David has not been able to get a loan to expand the business. Instead, David wants to fully utilize the machines they already have. In 2013, they used a little under 8,500 machine hours (as shown in Exhibit 1) and the existing five machines have a total of 9,300 machine hours available during the year (assuming normal maintenance and some repairs needed during the year). Thus, the existing machines have approximately 800 additional hours available for use. David wants to keep producing and selling all four of his product lines because many of the beer distributors like buying from breweries that offer several different beers. However, he wants to direct the salespeople to emphasize a certain product when they are out talking to the beer distributors. Given the current machine availability, David is not sure what beer product line to tell the sales people to emphasize in order to maximize his profits.

Finally, David and his family love root beer. Root beer follows a somewhat similar process to beer in that the ingredients are mixed together to form a “culture” that then goes through fermenting, filtering, and filling. Root beer would not need to be aged or stored in the refrigerator. There is an empty area in the current microbrewery facility that could be dedicated to making root beer. As a result, David has been talking with his family about producing and selling a line of specialty root beer. Root beer would be produced using different machinery rather than the existing five beer machines. David’s sister knows someone who is getting out of the soda business and would be willing to sell the used machinery needed to make the root beer for $8,000. Based on market research he has done, David thinks that he could charge $16.50 per case of root beer. Based on the same market research, there is a lot of uncertainty in how many cases of root beer the company could sell. David is less familiar with the root beer market and there is a wide range in sales of specialty root beer in the local groceries. Based on his understanding of the market, he thinks he could sell between 3,000 and 12,000 cases of root beer per year with likely sales of about 6,000 cases.

Root beer could be sold to some of his current distributors. However, soda does not need to be sold through the three-tier system that is required for alcohol sales. Therefore, much of the root beer sales would be directly to upscale groceries such as La Grande Orange Grocery and Pizzeria in Phoenix and Whole Foods and AJ’s Fine Foods with locations throughout Arizona. David could produce the root beer in-house or out-source the production. David has talked with another company who could produce the root beer for TM using David’s recipe and TM could sell it as their brand (this option is referred to as “private label”). It could be purchased from this other company for $13.05 per case. TM would still need to incur some variable handling costs and some minor fixed costs. Alternatively TM could produce the root beer in house. See Exhibit 3 for estimated cost information.

You have been hired as a consultant to help David with the business. Please address the following questions in preparation for your discussions with him.

1. Ignore any current plans. Using last year’s actual data and sales mix, how many total cases would David need to sell in order to earn $80,000 before tax? How many cases of each of the four labels would TM need to produce?

2. In Question 1, you identified the total number of cases the company needs to sell to earn $80,000 before tax. Assume you did the calculations in Question 1 correctly. However, before discussing your solution with the owner, identify and explain at least three issues related to you analysis and the assumptions employed in your analysis in Question 1 (discuss each concern; what it is and why it is a concern; do not just question general facts of the case such as why TM is charging a certain price for one product or how TM can reduce direct material cost.

3. Ignore the desire to earn $80,000 before tax and refer to the original data. David has a few options regarding Sedona Stout pricing: (a) keep the sales price the same (no change), (b) increase the sales price, or (c) decrease the sales price. What would you recommend he do and why? Provide both quantitative and qualitative analysis.

4. Next, ignoring the Sedona Stout information, consider David’s question regarding what product line the sales people should emphasize. David wants their sales efforts to maximize profits and utilize the company’s current capacity. What would you tell him? Explain your rationale.

5. Analyzing the sales forecast for root beer, what preliminary course of action do you recommend (in-house or out-source production) and why? Support your recommendations with numbers.

Exhibit 1
2013 Cost and Sales Information
Panel A: Per Case Information
	Saguaro Pale Ale	Bisbee Bock	Ocotillo Amber Pilsner	Sedona Stout	Total
Sales price	$21.00	$24.50	$23.50	$26.50
Direct materials	2.75	2.90	3.15	4.00
Direct labor	3.75	3.75	3.00	5.25
Variable overhead	5.90	6.18	6.10	6.34
Total variable cost	12.40	12.83	12.25	15.59
Contribution margin	$8.60	$11.67	$11.25	$10.91
Cases sold last year	12,593	7,126	6,827	4,184	30,730
Direct labor hours per case	0.25	0.25	0.20	0.35
Total direct labor hours last year	3,148.25	1,781.50	1,365.40	1,464.40	7,759.55
Machine hours per case	0.20	0.40	0.30	0.25
Total machine hours last year	2,518.60	2,850.40	2,048.10	1,046.00	8,463.10
Panel B: Contribution Margin Income Statement
Sales	264,453.00	$174,587.00	$160,434.50	$110,876.00	$710,350.50
Variable costs	156,153.20	91,426.58	83,630.75	65,228.56	396,439.09
Contribution margin	108,299.80	83,160.42	76,803.75	45,647.44	313,911.41
Direct fixed costs	10,329.62	8,392.91	6,017.39	9,893.92	34,633.84
Segment margin	$97,970.18	$74,767.51	$70,786.36	$35,753.52	279,277.57
Common fixed costs					245,389.44
Operating income					33,888.13
Taxes (35%)					11,860.85
Net income					$22,027.28

Exhibit 2
Additional Cost Information
Panel A: Details of Total Variable Costs
Direct materials	$ 93,537.20
Direct labor	116,393.25
Production supplies	26,064.41
Variable portion of maintenance	40,892.55
Variable portion of utilities	27,610.57
Variable office supplies	3,493.88
Shipping costs	31,619.19
8% sales commission	56,828.04
Total variable costs	$396,439.09
Panel B: Details of Total Fixed Costs (Direct and Indirect)
Brew master/quality control manager	$ 60,293.15
Receiving and shipping department expenses	22,511.32
Depreciation	11,712.10
Facility costs (rent, taxes, insurance, etc.)	78,938.15
Advertising and marketing costs	22,994.91
Fixed portion of maintenance	9,992.98
Fixed portion of utilities (including refrigeration)	10,390.37
Fixed portion of office supplies	4,305.66
Fixed salary of salespeople	32,221.81
Administrative staff to assist owner	26,662.83
Total fixed costs	$280,023.28

Exhibit 3
Root Beer Cost Information
Panel A: Alternative 1 – produce in-house
Direct materials per case	$1.75
Direct labor per case	2.25
Variable overhead per case	3.50
Total variable costs per case	$7.50
Additional fixed costs per year – not including   the initial purchase cost of the machine	$37,640.00
Panel B: Alternative 2 – out-source production
Purchase price per case	$13.05
Variable overhead per case	0.25
Total variable costs per case	$13.30
Additional fixed costs per year	$6,000.00

Answer 1

	Selling Price per case	$                                           16.50
	Panel A: Alternative 1
	Produce In-house
	Direct material per case	$                                              1.75
	Direct lobour per case	$                                              2.25
	Variable overhead per case	$                                              3.60
	Total variable cost	$                                              7.60
	Additional Fixed Costs (per year)	$                                   37,640.00
	Contribution per case	$                                              8.90	(16.50-7.60)
	Contribution margin ratio	=Contribution/Selling Price
		=8.90/16.50
		54%
	Break-even point(in Units)	= Fixed cost/Contribution per case
		=$37640/8.90
		4,229
	Panal B : Alternative 2
	Out-Source Production
	Purchase price per case	$                                           13.05
	Variable overhead per case	$                                              0.10
	Total variable cost per case	$                                           13.15
	Additional Fixed Costs (per year)	$                                     6,000.00
	Contribution per case	$                                              3.35	(16.50-13.15)
	Contribution margin ratio	=Contribution/Selling Price
		=3.35/16.50
		20%
	Break-even point(in Units)	= Fixed cost/Contribution per case
		=$6000/3.35
		1,791
	Point of Indifference	= Difference in fixed cost/Difference in Variable cost
		=(37640-6000)/(13.15-7.6)
		5,701
	Sales	Action
	Upto 5700 units	Out-source Production
	5701	Out-source Production/Produce In-house
	Above 5701	Produce In-house
	At 5701 Units cost would be the same in both case i.e. Out-source or in-house production
	Sales	5701 Units
		In-house Production	Out-Source Production
	Variable Cost	$                                   43,327.60	$             74,968.15
	Fixed Cost	$                                   37,640.00	$                6,000.00
	Total cost	$                                   80,967.60	$             80,968.15
	If the sales are likely to be 6,000 units he should produce in-house as it will be more profitable.
	Operating Profit at sales 6,000 units
		In-house Production		Out-Source Production
	Sales	$                                   99,000.00	(6000*16.5)	$         99,000.00	(6000*16.5)
	Less: Variable Cost	$                                 (45,600.00)	(6000*7.60)	$      (78,900.00)	(6000*13.15)
	Less: Fixed Cost	$                                 (37,640.00)		$         (6,000.00)
	Operating Profit	$                                   15,760.00		$         14,100.00
	Operating Leverage	3.39		1.43
	=Contribution/Operating profit	=(99000-45600)/15760		=(99000-78900)/14100