Question

Downward demand spiral. Network Company is a large manufacturer of optical storage systems based in Arizona. Its practical annual capacity is 7,500 units, and, for the past few years, its budgeted and actual sales and production volume have been 7,500 units per year. Network’s budgeted and actual variable manufacturing costs are $100 per unit, and budgeted and actual total fixed manufacturing costs are $2,250,000 per year. Network calculates full manufacturing cost per unit as the sum of the variable manufacturing cost per unit and the fixed manufacturing costs allocated to the budgeted units produced. Selling price is set at a 100% markup to full manufacturing cost per unit.

1. Compute Network’s selling price.

2. Recent competition from abroad has caused a drop in budgeted production and sales volume to 6,000 units per year, and analysts are predicting further declines. If Network continues to use budgeted production as the denominator level, calculate its new selling price.

3. Comment on the effect that changes in budgeted production have on selling price. Suggest another denominator level that Network might use for its pricing decision. Justify your choice.

4. Network has received an offer to buy identical storage units for $400 each instead of manufacturing r units in-house. Shutting down the manufacturing plant would reduce fixed costs to $450,000 per year. At what level of expected annual sales (in units) should Network accept this offer? Explain your answer.

Answer 1

Downward demand spiral.

1. and 2.

 

3.         

We can see that when the budgeted production is used as the denominator level and this level changes with anticipated demand, then the full manufacturing cost per unit and therefore the selling price can be quite sensitive to the denominator level. In this case, the denominator level has fallen by 20% [(7,500 – 6,000) ÷ 7,500] and the allocated fixed cost has increased by 25% [($375 – $300) ÷ 300], resulting in an 18.75% [($950 – $800) ÷ $800] increase in selling price. If Network’s market is becoming more competitive because of foreign entrants, raising the selling price could further drive away customers, lower the budgeted capacity and raise the fixed cost per unit, that is, lead to a downward spiral. If Network’s production plant was built for a practical capacity of 7,500 units, a denominator level of 7,500 units should be used, and the cost of excess capacity should not be charged to the units produced and sold. This will focus managerial attention on the unused capacity. If the competitive trends continue, Network will need to cut back its installed capacity to stay competitive.

 

4.         

Suppose Network sells x units each year. Its total cost to manufacture the x units would be $100x + $2,250,000. Its total cost to purchase x units would be $400x + $450,000. Therefore, Network should manufacture in-house, if $100x + $2,250,000 < $400x + $450,000; i.e., if x > 6,000 units. In-house, the cost structure is a low variable cost, high fixed cost structure, and only worth pursuing for high volumes. The source-outside cost structure is a high variable cost, low fixed cost structure, and only worth pursuing for small volumes. Currently, demand is exactly at 6,000 units. Network should conduct some research to forecast future demand patterns. If it seems likely that demand is going to fall below 6,000, it may be better to shut down its production capacity and outsource all of its needed units. This may also allow the management to examine and pursue other business options, as its current business gets increasingly competitive.

This may also allow the management to examine and pursue other business options, as its current business gets increasingly competitive.