ACCOUNTING-n my opinion, it will be a mistake if the new plant is built

ACCOUNTING 203 (chapter 5,6,7)

“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.
REQUIRED:
1.
Assuming that the company
continues with its present production setup:
a.
Compute the break-even point in
sales dollars (2.5 pts.)
b.
Prepare a contribution format
Income Statement for 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

Assume that cost behavior patterns remain
stable over the three-year period.
c.
Refer to the computations in
(b) above. Compute the operating leverage and the margin of safety percentage
for each year. (2.5 pts.)

2.
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.

a.
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.)
b.
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.)