Question

Cost function, breakeven, target profit, uncertainties and bias, interpretation  

Joe Davies is thinking about starting a company to produce carved wooden clocks. He loves making the clocks. He sees it as an opportunity to be his own boss, making a living doing what he likes best.
Joe paid $300 for the plans for the first clock, and he has already purchased new equipment costing $2,000 to manufacture the clocks. He estimates that it will cost $30 in materials (wood, clock mechanism, and so on) to make each clock. If he decides to build clocks full time, he will need to rent office and manufacturing space, which he thinks would cost $2,500 per month for rent plus another $300 per month for various utility bills. Joe would perform all of the manufacturing and run the office, and he would like to pay himself a salary of $3,000 per month so that he would have enough money to live on. Because he does not want to take time away from manufacturing to sell the clocks, he plans to hire two salespeople at a base salary of $1,000 each per month plus a commission of $7 per clock.
Joe plans to sell each clock for $225. He believes that he can produce and sell 300 clocks in December for Christmas, but he is not sure what the sales will be during the rest of the year. However, he is fairly sure that the clocks will be popular because he has been selling similar items as a sideline for several years. Overall, he is confident that he can pay all of his business costs, pay himself the monthly salary of $3,000, and earn at least $4,000 more than that per month. (Ignore income taxes.)

The following questions will help you analyze the information for this problem.

A. Identify uncertainties about the CVP calculations:
1. Explain why Joe cannot know for sure whether his actual costs will be the same dollar amounts that he estimated. In your explanation, identify as many uncertainties as you can. (Hint: For each of the costs Joe identified, think about reasons why the actual cost might be different than the amount he estimated.)
2. Identify possible costs for Joe’s business that he has not identified. List as many additional types of cost as you can.
3. Explain why Joe cannot know for sure how many clocks he will sell each year. In your explanation, identify as many uncertainties as you can.
B. Discuss whether Joe is likely to be biased in his revenue and cost estimates.
C. Explain how uncertainties and Joe’s potential biases might affect interpretation of the breakeven analysis results.

Answer 1

• A.

1.

$300 for the plans for the first clock: Uncertain, because Size of clock isnt mentioned. Plans may differ according to sizes. Thereby it can result in differing the plan cost.

new equipment costing $2,000: Certain

$30 in materials (wood, clock mechanism, and so on): Uncertain, because costs such as Glass, Battery cells, Hooks etc isnt mentioned.

office and manufacturing space, rent of $2,500 per month: Uncertain, because It may happen that due to unforseen circumstance Joe has to vaccate this offic & space, such as discretion of landlord, destruction due to natural calamitiesetc. It may result in differing the rent cost when new office & space will be needed to be taken on rent.

$300 per month for various utility bills: Uncertain, because possibility of human error may require more power (electricity) to get the things rectified. It may increase power consumption thereby differing the cost of utility bills.

Own salary of $3,000 per month: Uncertain, since if Joe gets married he may require more money for himself and his wife to survive.

salespeople at a base salary of $1,000 each per month plus a commission of $7 per clock: Certain.

2. possible costs:

i) Glass cost, sound system cost, battery cells cost etc as raw materials.

ii) Marketing & promotion cost

iii) Office & space maintenance cost (cleaning, repairing, water charges etc).

iv) Service cost of Clock (After sales).

v) Transportation & conveyance cost of sales people.

3. Joe cannot know for sure how many clocks he will sell each year because,

i) He has not made a sales target strategy.

ii) He has not made marketing & promotion strategy

iii) Demand may vary due to trends

iv) Unforseen circumstances may lead to lesser production such as early vaccating of office space, power shortage etc which may lead to less sales.

• B. Yes, Joe is likely to be biased in his estimates of cost & revenue. He seems over optimistic at one time and uncertain at other time. He has no clearly defined sales & marketing strategy which is of utmost important. Just appointing sales people may not yield desired results. Proper sales & marketing strategy needs to be worked out.

• C. Uncertainties and Joe’s potential biases might affect interpretation of the breakeven analysis results,beacuse it may result in No sale or less sale then Breakeven due to lack of proper sales & marketing strategy this may hamper his startup intiative thereby leading to mental and emotional morale downing.

             There are many costs which Joe has either forgot or has ignored which can affect pricing of product thereby making losses on sale. So a proper Costing & pricing strategy is also needs to be made.