Case Scenario:
You are the Division Manager for personal computers at Technology Unlimited. As the Division Manager, you are responsible for deciding which PC’s to manufacture. Currently your division manufactures three different models of personal computers:
1. Your Entry Level PC is losing money. Sales are $200,000 on 20,000 units. Variable costs are $100,000 and fixed costs are $110,000, for an overall loss of $10,000.
2. The Standard PC is making money. Sales are $450,000 on 30,000 units, with variable costs of $270,000 and fixed costs of $165,000 for an overall profit of $15,000.
3. The Deluxe PC is making the big bucks for the division. Sales are $1,000,000 on 50,000 units, with variable costs of 600,000 and fixed costs of 275,000 for an overall profit of $125,000.
The president of the company is Nancy Williams. She suggests dropping the Entry Level model and concentrating on the two other models. You reply that this would lead to a cost allocation death spiral. She says, “Prove it, or drop the Entry Level model”.
Analyze the information and prepare a briefing to Nancy. What will be the effect on the Standard and Deluxe models if you drop the Entry Level model? How strongly should argue for or against the Entry Level PC based on your financial analysis as well as opposition to the model by the president of the company?
Deliverable 1 – Cost Allocation
Create a table for the financial information if the three product lines are continued with no changes.
Then, create a second table to show what happens if the Entry Level PC is dropped. If either the Standard of Deluxe models then show a loss as a result of dropping the Entry Level model, then create a third table showing the result of dropping any other unprofitable models.
|
Variable costs |
Fixed costs |
No. of units |
Fixed cost per unit |
Sales |
Profit (loss) |
| Entry level PC |
$100,000.00 |
$110,000.00 |
20,000 |
$5.50 |
$200,000.00 |
($10,000.00) |
| Standard PC |
$270,000.00 |
$165,000.00 |
30,000 |
$5.50 |
$450,000.00 |
$15,000.00 |
| Deluxe PC |
$600,000.00 |
$275,000.00 |
50,000 |
$5.50 |
$1,000,000.00 |
$125,000.00 |
| Total |
|
$550,000.00 |
100,000 |
$5.50 |
|
|
Igor Khoroshilov:
If we drop the unprofitable Entry level PCs, then we would need to allocate the fixed costs between the other 2 models. Hence we would get:
| Standard PC |
$270,000.00 |
$206,250.00 |
30,000 |
$6.88 |
$450,000.00 |
($26,250.00) |
| Deluxe PC |
$600,000.00 |
$343,750.00 |
50,000 |
$6.88 |
$1,000,000.00 |
$56,250.00 |
| Total |
|
$550,000.00 |
80,000 |
$6.88 |
|
|
Igor Khoroshilov:
Now if we drop the unprofitable Standard level PCs, then we would need to allocate all the fixed costs to the deluxe model. Hence we would get:
| Deluxe PC |
$600,000.00 |
$550,000.00 |
50,000 |
$11.00 |
$1,000,000.00 |
($150,000.00) |
| Total |
|
$550,000.00 |
50,000 |
$11.00 |
|
|
Igor Khoroshilov:
As we can see, the result is indeed cost allocation death spiral, i.e. dropping an unprofitable model leads to other models being unprofitable and the trend goes until the entire production gets unprofitable. That supports your opinion that the Entry level PCs should not be dropped.
Deliverable 2 – Cover Memo & Background Info
Create a cover memo for your president that summarizes the financial information in the table. Decide how strongly you want to argue in favor or against the Entry Level PC and make your case.
The deliverable for this is a Word document with a memo as well as the information from the first deliverable (deliverable 1).