Question

David Happy has developed a new product that he is considering the production and selling of it. To proceed with this project, David will be renting a small building to rent for $1,250 a month that will house production facilities. Utility cost of building is expected to be $400 per month. One major piece of equipment that will be used to manufacture the product will be rented for $600 a month. Material costs to make the product are estimated at $8 per unit. Monthly advertising costs for the product are estimated at $1,000. David will be using salespeople for selling the product. Sales commission is $4.00 per unit. David has rented a truck for delivery of the products to customer at $350 per month. David will be paying himself $5,000 per month as salary. David will be spending about 75% of his time for manufacturing the product and 25% for promotion and delivery of the product. Answer the following independent questions.

1. Assume David has set a selling price per unit of $20 for his new product and is producing/selling 2,000 units per month. If the sales volume increases by 15% with no change in total fixed expenses, what will be the change in David’s net operating income?

2. Assume, David through investigation has determined the following possible sales scenarios with associated probability for his new product:

Sales Units            Probability

1,000                       50%

2,000                       20%

3,000                       15%

4,000                       10%

5,000                        5%

Given this data, should David start the new business? Why?

Answer 1

1		Base Case	Increase by 15%
	Sales Units (A)	2,000	2,300
			(2000*115%)
	Selling Price (B)	20	20
	Sales Revenue (C= A*B)	40,000	46,000
	Material Costs (8 per unit)	16,000	18,400
	Sales Commission (4 per unit)	8,000	9,200
	Rent	1,250	1,250
	Utility Cost	400	400
	Rent of Equipment	600	600
	Advertising cost	1,000	1,000
	Truck Rent	350	350
	David's salary	5,000	5,000
	Total Expenses (D)	32,600	36,200
	Net Operating Income (E=C-D)	7,400	9,800
	Change in net operating income =	9800-7400
	=	2,400

2	Sales Units (A)	Probability (B)	A*B
	1000	50%	500
	2000	20%	400
	3000	15%	450
	4000	10%	400
	5000	5%	250
			2000
	Based on above, David's sale should be 2000 units a month
	At 2000 units David has an operating income of 7400$.
	Since David is making positive profit, David should start the business