Question

As you know, we have been renting Building X for several yearsto the Smith Company for $30,000 per year. Their lease expires atthe end of the year. Instead of renewing the lease, I have beenthinking that we should use that part of our plant to manufacture anew product. The direct materials cost for the new product willtotal $80 per unit. To have a place to store finished units of theproduct, we will rent a small warehouse nearby. The rental costwill be $500 per month. In addition, we must rent equipment for usein producing the new product; the rental cost will be $4,000 permonth. We will hire workers to manufacture the new product, withthe direct labor cost amounting to $60 per unit. The space inBuilding X will continue to be depreciated on a straight-linebasis, as in prior years. This depreciation is $8,000 per year.Advertising costs for the new product will total $50,000 per year.I am going to hire a supervisor to oversee production; her salarywill be $3,500 per month. Electricity for operating the machineswill be $1 per unit. The cost of shipping the new product tocustomers will be $9 per unit. To provide funds to purchasematerials, meet payroll, and so forth, we will have to liquidatesome temporary investments. These investments are presentlyyielding a return of about $3,000 per year. I would like to sellthe new product for $200 per unit. The marketing department thinksthat at that price we should be able to sell 4,000 units everyyear. Please review the costs below and let me know if you thinkthe costs should be classified as a product cost, a period cost, oran opportunity cost (pick one). I also would like to know if thebehavior of the product cost or period cost is fixed or variable.Opportunity costs should not be classified as fixed or variable.(Hint: There are two opportunity costs in this problem. They arethe two items that are ‘revenue’ in the list of costs.) Name ofCost Variable or Fixed Cost Product Cost Period Cost OpportunityCost Rental revenue (from Smith Co.) forgone, $30,000 per yearDirect materials cost, $80 per unit Rental cost of warehouse, $500per month Rental cost of equipment, $4,000 per month Direct laborcost, $60 per unit Depreciation of Building X, $8,000 per yearAdvertising cost, $50,000 per year Supervisor’s salary, $3,500 permonth Electricity for machines, $1 per unit Shipping cost, $9 perunit Revenue earned on investments, $3,000 per year Based on theinformation above, do you think we should manufacture the newproduct or should we continue to rent to Smith Company? In thespace below and on the next pages, please provide me with numbersto support your answer. Are there any costs that are not relevantin this decision? How many units do we need to sell in order to‘break even?’ Option 1: Continue to rent to Smith Company Rentalrevenue from Smith _______________ Investment revenue_______________ Total revenue _______________ Expenses:________________________ _______________ Net operating income_______________ Option 2: Manufacture the new product Henry HawkinsIndustries Contribution Format Income Statement: New Product Forthe Year Total Per Unit Sales (4,000 units) $800,000 $200 Variableexpenses: _____________________ _______________ ___________________________ _______________ ______ ____________________________________ ______ _____________________ _______________ ______Total variable expenses _______________ ______ Contribution margin_______________ ______ Fixed expenses: ____________________________________ _____________________ ____________________________________ _______________ ____________________________________ _____________________ _______________ Total fixedexpenses _______________ Net operating income _______________Questions: 1. Do you recommend Option 1 or Option 2? 2. Which costis not relevant to the decision? (Hint: which cost shows up in bothoptions.) 3. How many units of the new product do we need to sellin order to ‘break-even?’ (Break-even is where the net operatingincome is zero.)