9-36
(20 min.)
Downward demand spiral.
1. and 2.
Competitive
Original
Situation
Practical capacity (units)
7,500
7,500
Budgeted capacity (units)
7,500
6,000
Variable manufacturing cost per unit
$100
$100
Fixed manufacturing costs
$2,250,00
0
$2,250,000
Markup percentage
100%
100%
Manufacturing cost per unit
Variable
$100
$100
Fixed (fixed mfg costs
÷
budgeted capacity)
($2,250,000
÷
7,500; $2,250,000
÷
6,000)
300
375
Full manufacturing cost per unit
$400
$475
Selling Price (200% of full manuf. cost per unit)
$800
$950
3.
We can see that when the budgeted production is used as the denominator level and this
level changes with anticipated demand, then the full manufacturing cost per unit and therefore
the selling price can be quite sensitive to the denominator level. In this case, the denominator
level has fallen by 20% [(7,500 – 6,000)
÷
7,500] and the allocated fixed cost has increased by
25% [($375 – $300)
÷
300], resulting in an 18.75% [($950 – $800)
÷
$800] increase in selling
price. If Network’s market is becoming more competitive because of foreign entrants, raising the
selling price could further drive away customers, lower the budgeted capacity and raise the fixed
cost per unit, that is, lead to a downward spiral. If Network’s production plant was built for a
practical capacity of 7,500 units, a denominator level of 7,500 units should be used, and the cost
of excess capacity should not be charged to the units produced and sold. This will focus
managerial attention on the unused capacity. If the competitive trends continue, Network will
need to cut back its installed capacity to stay competitive.
4.
Suppose Network sells
x
units each year. Its total cost to manufacture the
x
units would
be $100
x
+ $2,250,000. Its total cost to purchase
x
units would be $400
x
+ $450,000. Therefore,
Network should manufacture in-house, if $100
x
+ $2,250,000 < $400
x
+ $450,000; i.e., if
x
>
6,000 units. In-house, the cost structure is a low variable cost, high fixed cost structure, and only
worth pursuing for high volumes. The source-outside cost structure is a high variable cost, low
fixed cost structure, and only worth pursuing for small volumes. Currently, demand is exactly at
6,000 units. Network should conduct some research to forecast future demand patterns. If it