Calibrated manufacturing makes an electronic component that is in great demand. The component sells for $20 each. Calibrated's current capacity is 10,000 units per week. For the last few months, however, the company has been receiving new orders at a rate of 14,000 units per week, and now has a substantial backlog. The company expects this order rate to continue, if it maintains price. Calibrated's current operating data follows:
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Sales Revenue
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$200,000
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Variable Costs
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$100,000
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Fixed Costs
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$80,000
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Pretax Profit
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$20,000
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For each incremental addition of 500 units of output weekly, Calibrated would need to purchase new equipment that would add $1,500 to weekly fixed costs. No other fixed costs would become incremental for this price change. Labor costs currently account for half of all variable costs. Additional hires, however, are expected to be more costly than the average of current employees because of their lower productivity. Although new hires are paid (wages + fringe benefits) only 80% of the current average, they can produce only two-thirds as much output per hour. Consequently, labor costs for additional output with new hires is 20% higher than the current average.
Calibrated is debating whether to keep its current price and expand to meet the demand or to raise its price to reduce demand somewhat before deciding whether or not to expand.
For purposes of this case assignment the calculations for questions 1 and 2 have been provided. Please answer questions 3 and 4.
1. How much would Calibrated's weekly profits increase if it expanded to meet the entire amount of its current excess demand?
Question 1:
$CM (before) = $20-$10 per unit
New Variable Cost = $5 + ($5 x 1.2) = $11
$CM (after expansion) = $20 - $11 = $9 per unit
Increase in Total Contribution Margin (9 x 4000) $36,000
Less Increase in Fixed Costs (8 x 1500) -$12,000
Net Profit Contribution from Expansion $24,000
2. Prepare an analysis of a 10% price increase
o Calculate the break-even sales quantity (percent and units)
o Calculate the new $ contribution margin per unit
%CM = 9/20 = .45 or 45%
Basic $BE = -10/45 + 10 = -.10/55 = -.18.18 or -18.2%
Unit BE = -.1818 x 14,000 = -2548 units
Notice that I have used a baseline of 14,000 units since this represents the demand at current price. You must also consider that a reduction in sales of this size enables the company to avoid five increases in semi-fixed costs (at $1,500 each) because 2500 fewer units of capacity would be required. To calculate the new dollar contribution margin per unit. It is $11: the new price, $22, minus the relevant variable costs, $11. The resulting breakeven which considers the semi-fixed costs would be:
Unit BE = -2548 + -5 x $1,500/11 = -3230 units
This indicates that the company can avoid still another 500 units of semi-fixed cost, so the final equation would be:
Unit BE = -2548 + -6 x $1,500/11 = -3,366 units
3. What risks might be to Calibrated of increasing price to maximize profit?
The risks to Calibrated if they increase prices to maximize profit is that it would decrease 5 semi-fixed cost (at $1,500 each)asthe number of units needed would increase by 2500.
4. What risks might there be to Calibrated of expanding output rather than reducing demand through a price increase.