Rocky Mountain Chocolates (RMC) experiences much greater demand during the holidays than during the remainder of the year. As shown in the table below, RMC currently is producing at capacity of 100,000 units per month. RMC owner and founder, Wilson, is now considering adding capacity to meet the higher levels of holiday demand. (Chocolates have a short shelf life so it is not possible to increase production earlier in the year and accumulate inventory to meet holiday demand.)
- Current Estimated Market
- Unit Sales Demand - units
- January - October 100,000/month 100,000/month
- November-December 100,000/month 300,000/month
Product information (per unit):
Selling price (wholesale) $10
Cost of Ingredients 3
Direct Labor 1
Overhead 4
Profit $ 2
Production currently takes place in the rented building where RMC was founded, using leased equipment that has been accumulated over the years. Ingredients and Direct Labor are variable costs. Overhead consists entirely of costs that do not vary with the quantity produced, such as the rent payments for the building and lease payments for the production equipment. Overhead is allocated based on direct labor dollars, where the current overhead rate is 400% = Total Annual Overhead/Total Annual DL$ = $4,800,000 / $1,200,000.
Wilson is considering moving production to a new, more modern facility that would triple production capacity from 100,000 units per month to 300,000 units per month, thus providing sufficient capacity to meet the holiday demand. The move to the new facility with higher production capacity would increase total annual overhead costs by 50%, from $4,800,000 to $7,200,000.
This pending decision was discussed at a recent meeting of the executive committee. Matt Fife, the executive vice-president for production spoke first: "I know that we would all like to be able to sell more during the holidays, but I just don't see how this makes any sense. We are going to be able to increase sales for just the last two months of each year, so we will be adding sales of 400,000 units a year. Our profit margin is $2 per unit. Why would we spend $2,400,000 to add $800,000 of profit?"
Bob Jaworski, the vice president of sales spoke next: "I'm not sure that I agree with Matt's reasoning, but I agree we don't want to spend all this money to increase holiday sales. If we increase our overhead costs by 50%, the overhead component of per unit cost is going to increase by 50% from $4 to $6, and our profit per unit is going to fall to zero. Why would we want to increase capacity and see our profit drop from $2,400,000 ($2 per unit on 1,200,000 units) to $0 ($0 per unit on 1,600,000 units)?"
Wilson was confused by these comments. He would like to add enough capacity to meet holiday demand, both because he thinks that will lead to happier customers, but also because he believes that wider availability during the holiday season might lead to greater demand throughout the remainder of the year. Specifically, he thinks that demand during the ten non-holiday months could increase by as much as 10,000 units per month. At the same time, he doesn't want to make any change that is going to decrease profits.
Required:
1) Briefly evaluate and explain Matt Fife's statement