David Happy has developed a new product that he is considering the production an

Question

David Happy has developed a new product that he is considering the production and selling of it. To proceed with this project, David will be renting a small building to rent for $1,250 a month that will house production facilities. Utility cost of building is expected to be $400 per month. One major piece of equipment that will be used to manufacture the product will be rented for $600 a month. Material costs to make the product are estimated at $8 per unit. Monthly advertising costs for the product are estimated at $1,000. David will be using salespeople for selling the product. Sales commission is $4.00 per unit. David has rented a truck for delivery of the products to customer at $350 per month. David will be paying himself $5,000 per month as salary. David will be spending about 75% of his time for manufacturing the product and 25% for promotion and delivery of the product. Answer the following independent questions.

1. Assume David has set a selling price per unit of $20 for his new product and is producing/selling 2,000 units per month. If the sales volume increases by 15% with no change in total fixed expenses, what will be the change in David’s net operating income?

2. Assume, David through investigation has determined the following possible sales scenarios with associated probability for his new product:

Sales Units            Probability

1,000                       50%

2,000                       20%

3,000                       15%

4,000                       10%

5,000                        5%

Given this data, should David start the new business? Why?

Explanation / Answer

1 Base Case Increase by 15% Sales Units (A)            2,000                       2,300 (2000*115%) Selling Price (B)                  20                             20 Sales Revenue (C= A*B)          40,000                     46,000 Material Costs (8 per unit)          16,000                     18,400 Sales Commission (4 per unit)            8,000                       9,200 Rent            1,250                       1,250 Utility Cost                400                           400 Rent of Equipment                600                           600 Advertising cost            1,000                       1,000 Truck Rent                350                           350 David's salary            5,000                       5,000 Total Expenses (D)          32,600                     36,200 Net Operating Income (E=C-D)            7,400                       9,800 Change in net operating income = 9800-7400 =            2,400 2 Sales Units (A) Probability (B) A*B 1000 50% 500 2000 20% 400 3000 15% 450 4000 10% 400 5000 5% 250 2000 Based on above, David's sale should be 2000 units a month At 2000 units David has an operating income of 7400$. Since David is making positive profit, David should start the business

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