Please help me with this question and find an answer: Artsy T-Shirts sells 100,0

Question

Please help me with this question and find an answer:

Artsy T-Shirts sells 100,000 shirts a year, priced at $14 each. The company can produce any number of shirts at a constant cost of $10 each. It is considering expanding its sales by lowering the price to $12.

What minimum increase in sales would be necessary in order to justify this expansion?

Firms that are successful sometimes take their profitability as a signal that they should expand. Why does this expansion sometimes get them in serious trouble?

Explanation / Answer

The basic profit equation is:

Revenue = Costs + Profit

Price x Quantity = Unit Cost x Quantity + profit

Or, Profit = Quantity x (Price - Unit Cost)

= 100,000 x $(14 - 10) = $400,000 [At current level]

To increase sales by lowering price & still retaining the same total profit, we need to determine that output.

Let the revised output be Q1.

So, Q1 x (Price - Cost) = $400,000

Q1 x $(12 - 10) = $400,000

Q1 = $400,000 / $2 = 200,000 units

So Artsy needs to double its output.

Expansion decisins based solely on profitability often ignores the issue of liquidity. A firm's liquidity determines how much liquid assets it holds in order to quickly convert into cash and/or pay off its liabilities, if need be. But most often, a firm that expands rapidly basis its high profitability situation, needs to fund its expansion from internal & external sources of financiang which depletes cash. If the firm goes ahead on equity financing, it has to pay out of its cash, which decreases liquidity. If it instead goes for debt financing, interest to be paid on the debt decraeses the profit and cash, impacting both profitability and liquidity adversely.

So, an expansion decision must be undertaken after carefully undergoing all the financial and non-financial growth metrics, and not on the basis of only one metric.

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