Question

Paul's Medical Equipment Company manufactures hospital beds. Its most popular model, Deluxe, sells for $5,000. It has variable costs totaling $2,800 and fixed costs of $1,000 per unit, based on an average production run of 5,000 units. It normally has four production runs a year, with $500,000 in setup costs each time. Plant capacity can handle up to six runs a year for a total of 30,000 beds. A competitor is introducing a new hospital bed similar to Deluxe that will sell for $4,000. Management believes it must lower the price to compete. Marketing believes that the new price will increase sales by 25% a year. The plant manager thinks that production can increase by 25% with the same level of fixed costs. The company sells all the Deluxe beds it can produce. Question 1: What is the annual operating income from Deluxe at the price of $5,000? Question 2: What is the annual operating income from Deluxe if the price is reduced to $4,000 and sales in units increase by 25%?

Answer 1

1

What is the annual operating income from Deluxe at the price of $5,000?

Sales (20,000*5000)		100000000
Less: Cost
Variable cost (20,000x2800)	56,000,000
Fixed cost (1000*5000*4)	20,000,000
Set up cost (500,000 x 4)	2000000
Total Cost		78,000,000
operating income		22,000,000

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Question 2: What is the annual operating income from Deluxe if the price is reduced to $4,000 and sales in units increase by 25%?

Sales (25,000*4000)		100000000
Less: Cost
Variable cost (25,000x2800)	70,000,000
Fixed cost will be same	20,000,000
Set up cost (500,000 x 5)	2500000
Total Cost		92,500,000
operating income		7,500,000