Due to an economic downturn, sales through gourmet shops and department stores have lagged expectations for the past two years. This has kept the product manager of the Premium Grade Ovenware from meeting his required target of producing a 25% return on sales of product. This return is measured by preparing an income statement containing the sales of this product less any expenses considered attributable to this product line. An attributable expense exists to benefit the product line. It is a cost that would be avoided if the product line were discontinued. Further, when calculating the required 25% return on sales, the product line profitability statement does not deduct any allocations for general and administrative costs. Exhibit 1 provides a product income statement for this line for the past 5 years.
In an effort to increase sales, design engineers modified the ovenware product slightly in 2006. They made it less expensive to produce (saving about 35 percent of variable production costs) but indistinguishable in looks and functionality from the original product. The modified product also resulted in increased product longevity of about ten percent. The product manager, excited about the modifications and cost savings, lowered the price by ten percent and presented the item at a national food industry show at the end of 2006. He proudly advertised the product as having exactly the same looks, safety features, and functionality of the original product. He offered the same product warranty of six months under normal use conditions. He then booked sales of 1,500,000 pieces to existing customers for first quarter delivery. Production commenced immediately to fill these first quarter orders.
During routine quality testing in production, personnel discovered a serious problem with the product. The ovenware, under a small range of extremely high cooking temperatures (450-500 degrees), would explode if set on a cold trivet or placed in the refrigerator. The explosion could potentially cause the person holding the ovenware to suffer serious cuts and substantial, permanent burns. Unfortunately, the seriousness of the problem was not known until after the production of the 1,500,000 pieces was nearly completed. Based on statistical testing, it appeared that the flaw only occurs about .25 percent of the time (one quarter of a percent).
The production, quality, and product managers met to discuss this issue. They felt that they had only two options. First, they could delay shipment, recycle the current production, and produce the original ovenware using old methods. Of course, the product would have to be sold at the ten percent price reduction while being produced with the old cost structure for six months. Customers would experience about a thirty-day delay in delivery and it is likely some would be so annoyed that they would cancel their orders. The product manager estimated that about one-third of the year's orders would be lost. In addition, this would likely cause those customers to be permanently lost to competitors. At the conclusion of the six months period, the problem would be solved and the product would achieve the 35% variable cost savings.
Second, they could ship the goods without calling attention to the problem and hope for the best. They would simply act surprised if any problem arose and pay for damages. With only a .25 percent (.0025) failure rate and only under a small range of temperatures, the risk of the flaw seemed quite small. Further, since the product exploded when set on a cold surface, perhaps no person would actually be hurt and the damages would be limited to broken ovenware replacement.
Under either alternative, production engineers would work on correcting the problem. Engineers felt that they could solve the problem by the end of the second quarter. If the first option were taken, it meant 6 months of old production under new reduced sales prices plus scrapping the existing flawed units. Under the second option, it meant 6 months of producing and selling flawed, new products. Then the problem would be corrected.
The managers decided that the risk of option two was worth taking and shipped the flawed products (without disclosing the potential hazards). They toned down the quality testing report results such that it appeared that the product might only crack (not explode). Within two months of shipment, things went well. Only 1,575 product claims were made, and none involved personal injury. Replacement items were provided and customers remained satisfied.
Question
Prepare the budgeted 2007 income statement for Premium Grade Ovenware that the production, quality, and product managers considered when they discussed the first option available to them.
a. Under that option, shipment would be delayed and about one third of the year's sales of 6,000,000 units would be lost.
b. Product would be sold at the 10% price reduction but produced under the old cost structure for six months (variable production costs of $5.55 per unit). After the six months the variable cost savings of 35% would be achieved.
c. Assume that recycling the current production would add $500,000 to the fixed production costs originally budgeted for 2007. In addition, the product line will incur an additional $2,000,000 in design engineering to solve the problem within a 6-month period (this will involve the use of overtime and consultants).
d. Other cost items would stay as originally budgeted for 2007. What would the product line's profit be under this alternative? What would the return on sales for the product line be?
Attachment:- Income statement.rar