Question

Jenna's Farm Market assembles beautiful hanging flower baskets that they sell for $25 each. They make and sell 1,000 per season. The variable cost of the baskets is $13.50. Fixed costs are $2 per basket. Assorted Growers, a local flower supplier, has offered to supply the 1,000 hanging flower baskets that Jenna's will need for the upcoming spring/summer season. If Jenna's decides to buy the flower baskets instead of making them, they could avoid 40% of the fixed cost per basket, but would still incur the other 60%.  

Suppose that Jenna’s can use the facility that is normally used for flower baskets to assemble a different product that can provide a contribution margin of $2,500. What is the maximum price Jenna’s would be willing to pay for each basket?

Answer 1

To find the mximum price that Jenna will be willing to pay Assorted Growers, we'll first undertake a cost benefit analysis of both the situations for Jenna.

• Case 1: Jenna produces and sells on her own.

Quantity sold will be 1000 and Price received per basket will be $25. Thus, total revenue will be $25,000.

On the cost side, one time charge of $13.50 and $2 for every basket made and sold. Thus total cost amounts to $13.50 + $2(1000) = $ 2,013.50.

Net profit that Jenna earns is = $ 25,000 - $ 2,013.50 = $ 22,986.50.

• Case 2: Jenna buys baskets from Assorted Growers at $ "x" per basket.

Quantity sold will be 1000 and Price received per basket will be $25. Thus, total revenue will be $25,000. Additionally, Jenna will put her spare facility to some other use and earn $ 2,500 more. Thus, total revenue increases to $27,500.

On the cost side, fixed cost i.e. $13.50 will reduce by 40% i.e. new fixed charge will be $8.1. And, Jenna pays $ 'x' for each basket and thus, total cost will be (8.1 + 1000x).

Net profit that Jenna earns is = $27,500 - (8.1 + 1000x)

For Jenna to be indifferent between the two possibilities, she will pay "x" if it equates her profits from both. Thus, maximum value for "x" can be identified by equating both the equations:

Thus, x = $4.5054 is the maximum that Jenna will be willing to pay for the baskets from Assorted Growers. Anything more will make it profitable for her to not buy the baskets and make them herself. On the contrary, anything less will make buying baskets from Assorted Growers even more lucrative.

Kindly note that question states fixed costs as $2 per basket which is absurd because fixed cost is not dependent upon units of production. Rather, the question seems to have swapped fixed costs with variable costs. Thus, the question has been solved keeping fixed costs as $13.50 and variable costs as $2 per basket. Regardless, answer would remain the same.

Thanks!