Assignment Task

Part 1:

Dudu company manufactures two products: Dotan and Topaz. The market price for Dotan is $40 and for Topaz is $8. The demand for Dotan is highly uncertain, and the product spoils within two days. For that reason, Dudu decided to make Dotan only on demand, and use the excess capacity for the manufacturing of the less profitable Topaz. The production process utilizes a machine that can be used for the production of either product at any particular point in time. Practical capacity is 2,500 machine hours. To manufacture one unit of either Dotan or Topaz takes one machine hour. Switching production between the two products involves set up cost of $50. The variable cost per unit of Dotan is $15 and of Topaz is $5. Dudu estimates demand of 500 units for Dotan (produced in 100 different set-ups) and can sell any quantity produced of Topaz.

Given the above estimations, Dudu can use one of the following production plans:

(i) Produce 500 units of Dotan (one set-up is required).

(ii) Produce 2,500 units of Topaz (one set-up is required).

(iii)Produce 500 units of Dotan and 2,000 units of Topaz (200 set-ups are required).

Assignment questions for part 1:

1. Assume Dudu currently uses production plan (iii), and allocates all overhead (including setup costs) based on machine hours. Find the cost per unit under this production plan. If Dudu uses (only) this traditional costing system to decide if plan (iii) is desirable, will he consider changing his production plan? Explain.
2. Just before reacting to the results of A, Dudu had attended a seminar describing “Activity Based Costing,” and realized that set-up costs should be allocated based on the number of set-ups. Find the cost per unit under production plan (iii) if Dudu adopts ABC. If Dudu uses (only) an ABC system to decide if plan (iii) is desirable, will he consider changing his production plan? Explain.
3. What is the most profitable alternative? Show in detail.
4. What is going on? Is the ABC idea flawed? Why or why not.

Part 2:

Recall the “Dummy” case discussed in relation to variance analysis and consider the following situation. Having been an innovator all along, Dummy Jeans finds itself in an enviable situation for its South American division. At the end of 2015, Dummy faces no competition worth mentioning in the South American market for its core product, raw unwashed jeans (RUJ), and can therefore act as a monopolist. In her strategy meeting for 2016, Jill, the CEO, discusses the market outlook with her marketing manager, Stan, and her chief strategist, Gwen. In particular, they are debating two possible sales prices, $33 or $40 (all data are in US$). Stan presents the result of market research his and Gwen’s staff have performed:

Stan: We have considered three possible demand scenarios: “Low,” “Intermediate,” and “High” demand. Our estimates for total market demand for RUJ is summarized in Table 1. There you see that we consider the Intermediate scenario the most realistic one (40% probability of occurring). Given our cost structure, we feel the high product price of $40 would be advisable, if it weren’t for the fact that it might attract competition. We have reasons to believe that SMARTY Jeans, an Australia-based apparel maker, considers entering the RUJ market in South America.

Gwen: Adding to Stan’s comments, our team thinks that entry by SMARTY may occur even if we price aggressively, although a lower product price might go a long way towards deterring entry. Our best estimate is a 40% probability of SMARTY entering if we were to price at $40. The entry probability would drop to 10% if we were to price at $33. If SMARTY does enter and we end up competing head-on, we expect our market share for RUJ to decline from 100% to 75%.

Stan: On the cost side, we received some input from Mary, the COO. For 2016 she expects unit variable costs (including manufacturing and selling) of $14. Her fixed cost budget is $2M, at least as long as we produce below annual output of 230,000 units. If production were to exceed 230,000, we’d have to lease another machine at an additional monthly fixed cost of $20,000. The lease contract has a minimum term of 12 months.

Having analyzed the data, Jill tentatively agrees with Gwen and Stan’s joint proposal to set the product price for 2016 aggressively at $33 to minimize the threat of entry by Smarty.

Assignment questions for part 2:

1. Given the available data, which pricing strategy would you recommend – and why?
2. Would your recommendation be any different if the current production capacity were 220,000 instead of 230,000 units? (That is, if the additional machine-lease cost were due for any production quantities exceeding 220,000 units.)
3. Would your recommendation be any different if there were no threat of entry?
4. As the year 2016 commences, actual sales turn out to be strong at the set price of $33. Early in the year already there is a consensus among the leadership team that the market is best approximated by the “High” demand scenario in Table 1. Effective April 1, 2016, Dummy has to lease an additional machine (at $20,000 per month) to accommodate the strong demand. In mid-May 2016, Gwen learns that SMARTY is at about to enter the market – Dummy’s aggressive pricing strategy was apparently not sufficient as a deterrent. Starting July 2016, Dummy finds itself competing head-on with SMARTY. Table 2 summarizes the actual income statement for Dummy’s South America division, splitting the year into the periods January-June (no competition) and July-December (competing with SMARTY). Conduct a variance analysis using the above information. (Hint: it makes sense to conduct the variance analysis separately for Jan-June and July-Dec, 2016.)
5. Think of creative ways to establish which demand scenario has been realized, Low, Intermediate, or High. For the purpose of flexible budgeting, is it sufficient just to look at Dummy’s sales quantity and the fact whether or not there was a competitor? What would be other data you’d want to know to help assess the performance of Dummy’s management team?
6. Comment on the inferences we can draw from the fixed cost variances.