Problem:
During 2001, Company A manufactured and sold 50,000 flags at $24 each. Existing production capacity is 60,000 flags per year.
In formulating the 2002 budget, management is faced with a number of decisions concerning product pricing and output. The following information is available:
1. A market survey shows that the sales volume depends largely on the selling price. For each $1 drop in selling price, sales volume would increases by 10,000 flags.
2. The company's expected cost structure for 2002 is as follows:
a. Fixed cost (regardless of production or sales activity, $360,000
b. Variable costs per flag (including production, selling, and administrative expenses), $16
3. To increase annual capacity from the present 60,000 to 90,000 flags, additional investment for plant, building, equipment, and the like, of $200,000 would be necessary. The estimated average life of the additional investment would be 10 years, so the fixed costs would increase by an average of $20,000 per year. (Expansion of less than 30,000 additional unity of capacity would cost only slightly less than $200,000.)
Indicate, with reasons, what the level of production and the selling price should be for the coming year. Also, indicate whether the company should approve the plant expansion. Show your calculations. Ignore tax considerations and the time value of money.