Question

(Note: This type of decision is similar to dropping a product line.) Nicholas Company manufactures a fast-bonding glue, normally producing and selling 46,000 litres of the glue each month. This glue, which is known as MJ-7, is used in the wood industry to manufacture plywood. The selling price of MJ-7 is $40 per litre, variable costs are $24 per litre, fixed manufacturing overhead costs in the plant total $264,500 per month, and the fixed selling costs total $354,200 per month.

     Strikes in the mills that purchase the bulk of the MJ-7 glue have caused Nicholas Company’s sales to temporarily drop to only 11,500 litres per month. Nicholas Company’s management estimates that the strikes will last for two months, after which sales of MJ-7 should return to normal. Due to the current low level of sales, Nicholas Company’s management is thinking about closing down the plant during the strike.

     If Nicholas Company does close down the plant, fixed manufacturing overhead costs can be reduced by $69,000 per month and fixed selling costs can be reduced by 10%. Start-up costs at the end of the shutdown period would total $16,840. Since Nicholas Company uses lean production methods, no inventories are on hand.

Required:
1-a. Assuming that the strikes continue for two months, compute the increase or decrease in income from closing the plant.

Net income is

by

in two months

2. At what level of sales (in litres) for the two-month period should Nicholas Company be indifferent between closing the plant and keeping it open? (Hint: This is a type of break-even analysis, except that the fixed-cost portion of your break-even computation should include only those fixed costs that are relevant (i.e., avoidable) over the two-month period.)

Level of sales

litres in two months

Answer 1

1		Plant Kept Open	Plant Closed	Difference
	Sales (11,500 x $40 x 2)	920,000	-	(920,000)
	Less: Variable expesnes (11,500 x $24 x 2)	552,000	-	(552,000)
	Contribution margin	368,000	-	368,000
	Less: Fixed Costs
	Fixed manufacturing overhead cost ($264,500 x 2, $195,500 x 2)	529,000	391,000	(138,000)
	Fixed selling cost ($354,200 x 2, $354,400 x 0.90 x 2)	708,400	637,560	(70,840)
	Total fixed cost	1,237,400	1,028,560	(208,840)
	net operating loss before start-up costs	(869,400)	(1,028,560)	(159,160)
	Start-up cost		(16,840)	(16,840)
	Net Operating Income/(Loss)	(869,400)	(1,045,400)	(176,000)
	Net Income decrease by $176,000 in two months
2	8,895	Litres
	Total Fixed cost avoided	159,160
	Less: Start-up costs	16,840
	Net avoidable costs	142,320
	Net avoidable costs/Contribution margin per unit	8,895	Litres
	($142,320/ $16.00)