Question

A model car can be purchased at a hobby store for $6. It is HO scale meaning it is 1/87 of the size of the actual van.

Plastic models of this type are made using an injection molding machine. A die is created out of special steel in the shape of the vehicle. Other molds are used for the wheels and other parts. Molten plastic, usually styrene, is pumped into the mold under pressure which forms the body of the vehicle. It is ejected from the mold, allowed to cool and then is later painted, assembled, boxed and sold. Items like this are normally sold to specialized distributors who sell to the hobby shop retailers. The hobby shop would usually pay about 50% of the retail price and the distributor would pay approx. 60% of the price the retailer paid. In selling the model, the manufacturer would typically make a gross profit of 33.3%, meaning its cost of the item is $1.20.

Assume that the cost of the die is $10,000 and it can be used to make 25,000 models before it wears out. If produced in house, the unit cost of the styrene material is $.10; the unit costs of painting each model are $.05 fixed and $.05 variable. The plastic box it is sold in costs $.15. The rest of the unit costs are split 2/3 fixed and 1/3 variable. The model can be produced in lots of 5,000 as warranted by sales demand.

A Chinese toy company has offered to supply the completed model for $.90 each plus $.15 for shipping, custom duties etc. provided the US company orders and pays for all 25,000 models at one time. If purchased from the Chinese company, no US worker would lose their job but there could be reduced overtime for the employees.

1) Describe the process the US company should use to critically evaluate whether or not to accept the offer from the Chinese company.

2) Prepare a schedule showing unit costs [fixed & variable] of the model and breakeven sales in $ and units IF the US company manufactures the model car and sells it to the distributor.

Answer 1

1). While evaluating the offer to check whether to accept it or not. US company should analyse the profits it is making when the models are manufactured by the company and the profits it will make by purchasing the models from the chinese manufacturer and selling to the distributors after considering the cost saving due to non making the models by the company. US company should do the following:
Alternative 1). Profit due to manufacturing models:
Sales                      $ XXX
Less Variable Cost   $ XXX
Contribution             $ XXX
Less: Fixed Cost     $ XXX
Profit                      $ XXX

Alternative 2). Profit when models are purchased.
Sales                     $ XXX
Less: Purchase price          $ XXX
Less: Other Cost                $ XXX (After savings in cost)
Profit                                 $ XXX

These two alternatives should be compared and the one with higher profit should be taken.

2). If the company manufactures the model cars.

Here other variable cost is calculated as: $1.2 - 0.10 - 0.05 - 0.05 - 0.15 = 0.85 / 3 = 0.2833 or 0.28 approx.
Fixed Cost is calcuated as $1.2 - $0.58 (Total Variable Cost) = 0.62 * 25000 units = $15500
Breakeven units = Fixed Cost / Contribution per unit. Here Breakeven units can be rounded off to 12705 unitsa and correspondingly sales also will be rounded off to 12705 * $1.8 = $22869