In my opinion, it will be a mistake if the new plant is built,” said Steven Webb

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In my opinion, it will be a mistake if the new plant is built,” said Steven Webber, controller of Tanka Toys. “Why, if that plant was in existence right now, we would be reporting a loss of $100,000 for the year 2014 rather than a profit, and 2014 sales have been the best in the history of the company. Mr. Webber was speaking of a new, automated production facility that Tanka Toys is considering building. The company was organized only seven years ago, but it is growing rapidly due to its innovative new toys. Annual sales since inception of the company, along with net income as a percentage of sales, are presented below: Year Sales Income as a percent of sales 2008 $ 800,000 7.4 2009 1,900,000 7.0 2010 2,600,000 6.1 2011 3,000,000 5.3 2012 2,400,000 1.2 2013 3,700,000 3.8 2014 4,000,000 3.0 Although the company has always been profitable, in recent years rising costs have cut into its profit margins. The main production plant was constructed in 2007, but growth has been greater than anyone anticipated, making it necessary to rent additional production and storage space in various locations around the country. This spreading out of production facilities has caused costs to rise, particularly since the company is somewhat limited in the amount of automated equipment that it can use and therefore must rely on training a large number of new workers each year during peak production seasons. Tanka Toys produces about 75 percent of its toys between April and September and only about 25 percent during the remainder of the year. This seasonal production pattern is followed by many toy manufacturers, since it saves on storage costs and reduces the chances of toy obsolescence due to style changes. Other toy manufacturers produce evenly during the year, thereby maintaining a stable work force. Carrie Russell, manufacturing vice-president of Tanka Toys, is pushing the new plant very hard, since it would permit Tanka toys to produce on a more even basis, as well as to automate many hand operations and thereby dramatically reduce variable costs. Tanka’s management recognizes that much of the company’s success is due to the creative efforts of Kayla Dernier, head of the company’s new products department. Kayla has developed new toys that have revolutionized some areas of the toy market. Her talents are now becoming recognized by competitors, and Tanka’s management is concerned that one of the competitors may be successful in “buying” her away from the company. Although total toy sales are quite stable, individual toy manufacturers can experience wide fluctuations from year to year according to how well their toys are received by the market. For example, Tanka Toys “missed the market” on one of its toy lines in 2012, causing a 20 percent drop in sales and a sharp drop in profits, as shown above. Other manufacturers have experienced even sharper drops in sales, some on a prolonged basis, and Tanka Toys feels fortunate in the sales stability that it has enjoyed. Mr. Webber points out that although variable costs will be reduced by the new plant, fixed costs will rise steeply, to $1,700,000 per year. On the other hand, fixed costs are now $450,000 per year. Mr. Webber is confident (and Ms. Russell agrees) that with stringent cost controls variable expenses can be held to 82 percent of sales if the company continues with it present production setup. Variable expenses will be 60 percent of sales if the new plant is built. Ms. Russell points out that marketing projections predict only a 10 percent annual growth rate in sales if the company continues with its present production setup, whereas sales growth is expected to be as much as 15 percent annually if the new plant is built. The new plant would provide ample capacity to meet projected sales needs for many years into the future. Economies of expansion dictate, however, that any expansion undertaken be made in one step, since expansion by stages is too costly to be a feasible alternative. Question. 1.Assuming that the company continues with its present production setup: Compute the break-even point in sales dollars (2.5 pts.) Prepare a contribution format Income Statementfor each of the next three years (2015 – 2017) using projected sales as follows (these figures assume a 10 percent growth rate in sales each year):(5 pts.) Year Sales 2015 $ 4,400,000 2016 4,840,000 2017 5,324,000 2.Assume that cost behavior patterns remain stable over the three-year period. Refer to the computations in (b) above. Compute the operating leverage and the margin of safety percentage for each year. (2.5 pts.) Assuming that the company builds the new plant, redo the computations in (1)(a), (1)(b), and (1)(c) above. Use projected sales as follows (these figures assume a 15 percent growth rate in sales each year):(10 pts.) Year Sales 2015 $ 4,600,000 2016 5,290,000 2017 6,083,500 3.Refer to the original data. Assume that Tanka Toys “misses the market” with its toy lines in 2015 and that sales fall by 20 percent to only $3,200,000 for the year. Compute the net profit or loss for the year with or without the new plant.(5 pts.) 4.Refer to the original data. Suppose that the company is anxious to earn a target profit of at least 12 percent on sales. At what sales level will the 12 percent target profit on sales be achieved if the new plant is built? According to the company’s projected sales growth, in what year will this sales level be reached?(2.5 pts.) At what sales level will the 12 percent target profit on sales be achieved if the company keeps its old plant? How long does it appear that it will take the company to reach this sales level?(2.5 pts.) 5.Based on the data in (1) – (4) above, evaluate the risks and merits of building the new plant and recommend to management the course of action that you think should be taken. (10 pts.) Criteria for Assessment of Essay: -The risks and merits of each choice were mentioned 1 2 3 4 5 -A choice was recommended to management 1 2 3 4 5 6.Individual Participation Points: (20 pts.) These points will be awarded based on the activity on your team’s Canvas discussion board. If you interact outside of the Canvas discussion board leave me a message on your discussion board indicating who was involved in the interaction

Explanation / Answer

Assuming current production set-up 1.Break-even point in sales dollars = Fixed costs/Contribution Margin Ratio 450000/(100-82)%= 2500000 Contribution format Income Statementfor each of the next three years 2015 2016 2017 Sales 4400000 4840000 5324000 Less: Variable costs@ 82% of Sales 3608000 3968800 4365680 Contribution Margin 792000 871200 958320 Less: Fixed Costs 450000 450000 450000 Net Income 342000 421200 508320 Contribution Margin Ratio 792000/4400000 0.18 0.18 0.18 2. Operating leverage Contribution/Net Inc. 792000/342000 2.32 2.07 1.89 Margin of safety Sales- Breakeven sales BES= 2500000 1900000 2340000 2824000 Assuming new plant set-up 1.Break-even point in sales dollars = Fixed costs/Contribution Margin Ratio 1700000/(100-60)%= 4250000 Contribution format Income Statementfor each of the next three years 2015 2016 2017 2018 2019 2020 Sales 4600000 5290000 6083500 6691850 7361035 8097139 Less: Variable costs@ 60% of Sales 2760000 3174000 3650100 Contribution Margin 1840000 2116000 2433400 Less: Fixed Costs 1700000 1700000 1700000 Net Income 140000 416000 733400 Contribution Margin Ratio 1840000/4600000 0.4 0.4 0.4 2. Operating leverage Contribution/Net Inc. 1840000/140000 13.14 5.09 3.32 Margin of safety Sales- Breakeven sales BES= 4250000 350000 1040000 1833500 Original data- Misses the market (Old plant) New Plant 2015 2015 Sales 3200000 3200000 Less: Variable costs@ 82% of Sales 2624000 60% V.C 1920000 Contribution Margin 576000 1280000 Less: Fixed Costs 450000 1700000 Net Income 126000 -420000 4. 12% Target profit on sales with new plant Verification Let that sales level be x, then, 6071429 Sales 12%*x=x-(60%*x)-1700000 3642857 60% V.c x= Sales level = 6071429 1700000 FC 728571.4 0.12 As per the estimates for the new plant this sales level of $ 6071429 will be achieved in the year 2017 4. 12% Target profit on sales with old plant Verification Let that sales level be x, then, 7500000 Sales 12%*x=x-(82%*x)-450000 6150000 82% V.c x= Sales level = 7500000 450000 FC 900000 0.12 As per the estimates for the old plant this sales level of $ 7500000 will be achieved sometime in the year 2020 (See Contribution format for old plant) Current production set-up Contribution Margin Ratio 0.18 0.18 0.18 Operating Leverage 2.32 2.07 1.89 Margin of Safety 1900000 2340000 2824000 Break even sales 2500000 Net Income if market is missed 126000 Target profit(Sales level 7500000 ) achieved in 2020 New plant set-up Contribution Margin Ratio 0.4 0.4 0.4 Operating Leverage 13.14 5.09 3.32 Margin of Safety 350000 1040000 1833500 Break even sales 4250000 Net Income if market is missed -420000 Target profit(Sales level 6071429) achieved in 2017 The new plant set-up is a highly leveraged one- with low variable costs and very high fixed costs(1700000)- which cannot be managed without the predicted level of (15%) growth every year. On the contrary, if the market is missed, it results in a loss due to the heavy burden of fixed costs. The merits are a high contribution margin and margin of safety.Target profit is also achieved earlier than the current one. New plant can be suggested only if the predicted sale levels are maintained. Otherwise, the current set=up is a safe-bet without any risks.

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