This case is comprised of various situations that deal with behavioral costs in order to maximize profits. The use of break-even analysis and opportunity cost is used along with recognizing and using the fixed and variable cost. The Hospital Supply, Inc. case is where they manufacture hydraulic hoists and have a normal volume of 3,000 units per month. Using a break-even analysis the determination of the sales volume and prices will reveal what the company will need to profitably sell its product. There are also scenarios given to determine which options to take to maximize profit or at least minimize loss.
Exhibit 1 displays the cost per unit for hydraulic hoists and will provide the information needed to determine how Hospital Supply Inc. can maximize its profit in the following various scenarios.
Part one is to determine both the break-even volume in units and in sales dollars. First we need to add all the variable costs per unit = $550 + $825 + $420 + $275 = $ 2,070 and fixed costs per unit = $660 + $770 = $1,430.
Given information within the problem include:
Normal volume = 3,000 units
Regular selling price = $4,350
To find total fixed cost = 3,000 units *$1,430/unit = $4,290,000
By taking the regular selling price and subtract the variable cost per unit gives the unit contribution:
= price/unit – variable cost/unit = $4,350 – $2,070 = $2,280
Contribution percent = $2,280/$4,350 = 0.524138
– Break-even volume in units = fixed cost/unit contribution = $4,290,000/$2,280 = 1,882 units
– Break-even volume in sales = fixed cost/ contribution percent = $4,290,000/$0.524138 = $8,184,867
Market research estimates that monthly volume could increase to 3,500 units, which is well within hoist production capacity limitations, if the price were cut from $4,350 to $3,850 per unit. Assuming the cost behavior patterns implied by the given data are correct, would you recommend that this action be taken?
Income (with regular price) = Revenues -Total costs = $13,050,000 – $10,500,000 = $2,550,000
After price reduction, income = $13,475,000-$11,535,000 = $1,940,000
In regards to problem 2, reducing the price would result in reduction of income, since $1,940,000 – $2,550,000 = $610,000. Even though price reduction has its advantages such as increasing demand, it greatly reduces income and wouldn’t recommend this approach.
A contract offer is made to Hospital Supply by the federal government is supply 500 units to VA hospitals for delivery by March 31. Because of an unusually large number from rush orders from its regular customers, Hospital Supply plans to produce 4,000 units during March, which will use all available capacity. If the government order is accepted, 500 units normally sold to regular customers will be lost to a competitor. The contract given by the government would reimburse the government share of March production costs, plus pay a fixed fee(profit) of $275,000. What impact would accepting the government contract have on March income?
If government contract is accepted: income from government = 500 x unit contribution
= 500units x $2,280/unit = $1,140,000
Profit from fixed fee = $275,000
Fixed manufacturing cost prorated = ($660/unit) x 3000 units x 500units / 4000 units = 990,000,000/4000 = $247,500
Differential income = income – profit fixed fee – prorated fixed manufacturing costs
= 1,140,000 – $275,000 – $247,500 = -$615,500
If the government contract is accepted, the negative differential income (-$615,500) in question 3 analysis indicates a loss, suggesting a bad deal. Therefore, I would suggest turning down the government offer.
Hospital Supply has an opportunity to enter a foreign market in which price competition is keen. An attraction to the foreign market is that demand there is greatest when the demand in the domestic market is quite low. Thus, idle production facilities could be used without affecting domestic business. An order for 1,000 units is being sought at a below-normal price in order to enter this market. Shipping costs for this order will amount to 410 per unit, while total costs of obtaining the contract will be $22,000.00. Domestic business would be unaffected by this order. What is the minimum unit price Hospital Supply should consider for this order of 1,000 units?
The minimum price to be considered = variable manufacturing costs plus shipping costs plus marketing cost. With marketing cost/unit = $22,000/1,000 = $22.
Then the minimum acceptable price equals ($550 + $825 + $420) + $410 + $22 = $2,227/ unit. At this price, there will be no profits. There are definitely advantages in selling in foreign market such as new market opportunity which could increase sales. However, fluctuation in currencies should be closely watched as well as shipping costs that could change from time to time.
An inventory of 200 units of an obsolete model of hoist remains in the stockroom. These must be sold through regular channels at reduced prices or the inventory will soon be valueless. What is the minimum price that would be acceptable in selling these units?
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Other than variable marketing costs, other costs related to the manufacture of these 200 units have been consumed. Therefore, any selling price above the differential costs would be automatically considered as an income. Since the 200 units have to be sold through regular channels at reduced prices, the differential cost per unit = variable marketing cost = $275 per unit. This price corresponds to the break-even price just for those 200 units.
A proposal is received from an outside contractor who will make 1,000 hydraulic hoist units per month and ship directly to Hospital Supply’s customers as orders are received from Hospital Supplies sales force. Hospital Supply’s fixed marketing costs would be unaffected, but its variable marketing costs would be cut by 20 percent for these 1,000 units produced by the contractor. Hospital Supply’s plant would operate at 2/3 of its normal level. And total fixed manufacturing costs would be cut by 30%. What in house units cost should be used to compare with the quotation from the supplier? Should the proposal be accepted for a price of $2475.00 per unit?
In-house cost (as shown above) equals $2,444 per unit. The proposal should not be accepted since it would reduce total income by $31,000.
Assume the same facts as in problem 6 except that the idle facilities would be used to purchase 800 modified hydraulic hoists per month for the use in hospital operating rooms. These modified hoists could be sold for $4,950 each, while the variable manufacturing costs would be $3,025 per unit. Variable marketing costs would be $550 per unit. Fixed marketing and manufacturing costs would be unchanged whether the original 3,000 regular hoists were manufactured or the mix of 2,000 regular hoists, plus 800 modified hoists was produced. What is the maximum purchase price per unit that Hospital Supply should be willing to pay the outside contractor? Should the proposal be accepted for a price of $2,475 per unit to the contractor?
Income with outsourcing = $17,010,000 – ($4,290,000 + $7,220,000) – payment to outsourcing company. Therefore, income = $5,550,000 – payment to outsourcing co.
As we see in analysis for question 7 above, with outsourcing, the income would be $5,500,000 – payment to outsourcing co., while income without outsourcing is $2,550,000. Therefore, the very maximum payment to outsourcing company should be: $5,500,000 – $2,550,000 = $2,950,000, or $2,950/unit.
In contrast to the previous problem, the proposed price of $2,475/unit is acceptable since it is below the maximum acceptable payment, which is $2,950.
This case, with the various problems, provides an opportunity to determine alternative results in order to capitalize on profits taking in account costs and entity total capacity. Important approaches and terms are also emphasized: break-even analysis, fixed costs, variable costs, overhead costs, target profit, unit contribution, differential income and contribution percent.