Question

Joe Smith has owned and operated Smith's Tool and Die for 40 years. Currently, he is only making one part, RL-5 which is a small electricial relay. He has a 2-year contract to provide 30,000 parts per month to Ford Motor. Unfortunately, Joe got quite sick and his son, Mike, has had to come in and run the business. Mike is disappointed when he finds the following monthly information about the RL-5 part: Per unit 30,000 units Sales Price: $22.00 660,000 Variable manufacturing costs $14.00 420,000 Variable selling costs $2.00 60,000 Fixed manufacturing overhead 150,000 Fixed administrative/selling costs 60,000 Operating income (30,000) Smith's Tool and Die has the capacity to produce 100,000 units of the RL-5 part per month. Mike comes to you to see what can be done about the current losses Smith's Tool and Die is experiencing. You and Mike determine that there are three alternatives to consider: 1. Mike mentions that his friend's dad, Sam, also owns a tool and shop and also supplies the RL-5 part to other automotive businesses. Sam's business is doing very well and can't keep up with current production. Sam offers to purchase 50,000 units of RL-5 from Mike for $15.00 per unit. Since this is Mike's deal, no additional selling costs will be incurred. 2. Mike is also thinking about shutting down the business. Since he needs to the honor his contract with Ford, he has looked into outsourcing the part to Fred's Tool and Die. Fred offers to make the 30,000 parts per month for a price of $20 per unit. Outsourcing the part will reduce fixed manufacturing overhead by $80,000 and fixed administrative and selling costs by $30,000. 3. Mike can pay Ford a non-performance fee and sell the assets of the business. The fee is 10% of the sales revenue for one year. Mike has received an offer from Tony who will pay $1,200,000 for the assets. Tony plans to sell what assets he can, demolish the building and build condos on the land. The current net book value of the assets is $200,000. Assume that Smith's tax rate on the gain is 21%.

5. How much profit/loss will Mike realize if he sells the assets of the business to Tony? Show all computations

6. List 3 qualitative issues that you think Mike should consider before selling off the business: A. B. C.

7. Assess all of the three alternatives. Which do you recommend Mike choose? Why? Use at least 5 complete sentences.

Answer 1

Particulars	Amount	Amount
5 - Calculation of Profit / Loss on sale of business
Sales Consideration		1,200,000
Less - Non Performance Fees (10% of (22*12*30,000)	792,000
Less - Book Value of Assets	200,000	9,92,000
Net Profit on sale of business		208,000
Tax payable on such profit @ 21%		43,680

6 - Qualitative factors to be considered before selling business -

A - Loss of reputation to Ford. B - Perhaps unable to enter similar business again due to non-compete clause in agreement and C - Permanent closure of any source of revenue.

7 - Best alternative out of the 3 -

Alt 1 - Sell to Sam at $15 for 50,000 units.

Particulars	Amount
Sales to Ford (30,000 * 22)	660,000
Sales to Sam (50,000 * 15)	750,000
Total	1,410,000
Less - Variable Costs (80,000 *14)	-1,120,000
Less - Variable Selling Costs (30,000 * 2)	-60,000
Less - Fixed Manufacturing Overheads	-150,000
Less - Fixed Administrative Costs	-60,000
Net Income	20,000

Alt 2 - Outsource to Fred at 20$ per unit.

Particulars	Amount
Sales to Ford (30,000 * 22)	660,000
Less - Purchase from Fred (30,000 * 20)	600,000
Less - Fixed Overheads (150,000 - 80,000)	70,000
Less - Fixed Administrative Costs (60,000 - 30,000)	30,000
Net Income	(40,000)

Looking at the above amounts, it is clear Mike should choose alternative 1.

For a start, it leaves him with 20,000$ every month.

This helps him in successfully turning the business around from a loss making one to a profit making.

It also leaves him with room to further increase production of 20,000 units, thereby increasing profits.

It also saves him loss of reputation and goodwill due to closure of such business.

Allows him to maintain the same quality and standards, which were not possible had he chosen to outsource to Fred.

I hope the above solution is what you were looking for. For any further queries or doubts in the solution, please feel free to drop a comment. Please do leave a positive feedback, Thank you :)