Cost-Volume-Profit Analysis (CVP)

Jay Hockey is thinking about starting a company to produce carved wooden clocks. He loves making the clocks. He sees it as an opportunity to be his own boss, making a living doing what he likes best.

Jay paid $300 for the plans for the first clock, and he has already purchased new equipment costing $2000 to manufacture the clocks. He estimates that it will cost $30 in materials (wood, clock mechanism, etc.) to make each clock. If he decides to build clocks full time, he will need to rent office and manufacturing space, which he thinks would cost $2500 per month for rent plus another $300 per month for various utility bills. Jay would perform all of the manufacturing and run the office, and he would like to pay himself a salary of $3000 per month so that he would have enough money to live on. Because he does not want to take time away from manufacturing to sell the clocks, he plans to hire two salespeople at a base salary of $1000 each per month plus a commission of $7 per clock.

Jay plans to sell each clock for $225. He believes that he can produce and sell 300 clocks in December for Christmas, but he is not sure what the sales will be during the rest of the year. However, he is fairly sure that the clocks will be popular because he has been selling similar items as a sideline for several years. Overall, he is confident that he can pay all of his business costs, pay himself the monthly salary of $3000, and earn at least $4000 more than that per month. (Ignore income taxes.)

Required

(a) Perform analyses to estimate the number of clocks Jay would need to manufacture and sell each year for his business to be financially successful:

(i) List all of the costs described and indicate whether each cost is (1) a relevant fixed cost, (2) a relevant variable cost, or (3) NOT relevant to Jay’s decision.

(ii) Calculate the contribution margin per unit and the contribution margin ratio.

(iii) Write down the total cost function for the clocks and calculate the annual breakeven point in units and in revenues.
(iv) How many clocks would Jay need to sell annually to earn his salary plus $4000 profit per month?

(b) Identify uncertainties about the CVP calculations:

(i) Explain why Jay cannot know for sure whether his actual costs will be the same dollar amounts that he estimated. In your explanation, identify as many uncertainties as you can. (Hint: For each of the costs Jay identified, think about reasons why the actual cost might be different than the amount he estimated.) (Word count: maximum 250 words)
(ii) Identify possible costs for Jay’s business that he has not identified. List and briefly describe five of these.
(iii) Explain why Jay cannot know for sure how many clocks he will sell each year. In your explanation, identify as many uncertainties as you can. (Word count: maximum 150 words).

(c) Discuss whether Jay is likely to be biased in his revenue and cost estimates. (Word count: maximum 100 words)